September 2019

[1495_sc]

Hello,

I have doubts related to all parts of question #1 in this sitting. Elaborating further below-

Note that I have solved quite a few questions related to TWRR and MWRR but this one caught me off guard in spite of hardly 4 marks being awarded for calculation.

Listing partwise questions below.

i) a)There are annual contributions to the pension each year although the impact of these allocations on unit price is not transparent. With the given information, I thought we would calculate TWRR for Fund A by solving the equation (1+i)^(3) =((90-8)/100)*((114-5)/90)*((133-2)/114) i.e i= 4.5%

However, the examiner's report is simply calculating it as (latest unit price/starting unit price)^(1/3)-1= (133/100)^(1/3)-1=9.97%

Why is my approach wrong and why is it as simple as (133/100)^(1/3)-1?

i)
b) The solution has following statements
No account has been made of cashflows - Is it because we calculated TWRR above and not MWRR?
Investment made in the middle of the period could have done better in Fund A - How?

ii) The solution is very confusing. If we assume that cashflow occurs at the end of the year, are we simultaneously assuming that unit price remains constant throughout the year (31 Dec 2015 - 30 Dec 2016) ? Is a 'year' in this question starting from 31 Dec 2015 unlike conventional financial year beginning from 1st Jan 2015?

I was thinking of the equation below for fund A, assuming that cashflows occur right after unit price is determined hence accumulated for the same period as unit price. Same assumption as cashflow occurring at the start of the period (31 Dec 2015 here)

133=100*(1+i)^(3)+8*(1+i)^(3)+5*(1+i)^(2)+2*(1+i)

Got a different solution because LHS= 153.36 in the solution. How is it 153.36?

Similarly, for fund B, LHS= 151.829 looks odd instead of 270! Please help.

iii) The solution has following statements which I didn't understand at all. How can we arrive at this conclusion?

Investment in fund A was weighted towards the beginning of the three-year period, those for fund B was weighted towards the end of the period.

Fund A's return was best towards the end of the period, whereas fund B's returns were best towards the start.

Please advise if I am being fundamentally wrong here. Will revise these topics accordingly.

Thank you in advance!

 

[1495_sc]

For Q3 in the same diet, the solution says that Dow Jones Industrial Average is not an investible index. I understand that being unweighted, it is not an ideal index but I know for a fact that there are ETFs available which replicate DJIA!

Check the link below for reference.

https://www.investopedia.com/etfs/etfs-track-dow/

 

[Joe Hook]

Hi,

ia) Cashflows into the fund alter the value of units but not the unit price. So the simplest way to calculate the TWRR is simply to look at the price changes in the units. Otherwise you could take a more "core-reading formula" approach to the question. For this to work we need to work out the fund value at each time point:

At time 0 we have £108m invested in the units at £1 each. At time 1 the fund value drops to £97.2m (108*0.9) at which point £5m is invested which purchase 5m/0.9 = 5.5556m units. At time 2 we have 113.5556m units worth £1.14 each which gives a fund value of £129.4534m. The further investment of £2m buys a further 1.7544m units. Then at time 3 we have 115.3099m units with a fund value of £153.3622m. The core-reading formula then calculates the TWRR as:

(1+i)^3 = (97.2/108)*(129.4534/102.2)*(153.3622/131.4534) = 1.33

as with the unit price only method.

ib) That's correct. E.g a single investment made on 31/12/2017 for a period of one year would have done better invested in A rather than B with a return of 16.7% rather than 6.3% over that period. By considering returns over the whole period we don't necessarily appreciate which investment strategy over that 3 years would have been best ie there may have been times at which we would have performed better in A than B as above.

ii) I think this is solved with my answer to part (i)(a) as well. It's all about the fund value in this case, because the value of the fund at the end is not 133 but 153.36 because the cashflows over the year have purchased extra units and so we've invested more than £100m.

iii) The pattern of the cashflows shows greater investment being made in fund A rather than B early in the period. With fund A's returns being best in the second and third years the pension scheme benefits from investing the money earlier rather than later. On the other hand fund B had it's best returns in the first year, but by investing later on in the 3 year period the trustees do not benefit from the higher return. As MWRR takes into account the timing of the cashflows, and the returns they have therefore benefited from, the MWRR on A is higher than B.

I don't think you've made any real fundamental mistakes here or if you've had it's the same one. Take a look at this question again with a fund value in mind (number of units * unit price) and I think it will start to make more sense.

Hope this helps
Joe

 

[Joe Hook]

Thanks for flagging on Q3. I suspect the examiners have gone a little too strong on the wording here. With SP5 it's very dangerous to say a certain fund or investment type does not exist because there are endless possibilities in the real world. I think we can probably agree that there seems little practical use in tracking the Dow Jones, but it wouldn't necessarily stop people doing so. I'd have thought the practicalities of having to rebalance the constituents constantly would be enough to put anyone off, but clearly not.

I think the wording of our ASET is a little softer on this but I'll take this away nonetheless.

Thanks again
Joe

 

[1495_sc]

Hi,

ia) Cashflows into the fund alter the value of units but not the unit price. So the simplest way to calculate the TWRR is simply to look at the price changes in the units. Otherwise you could take a more "core-reading formula" approach to the question. For this to work we need to work out the fund value at each time point:

At time 0 we have £108m invested in the units at £1 each. At time 1 the fund value drops to £97.2m (108*0.9) at which point £5m is invested which purchase 5m/0.9 = 5.5556m units. At time 2 we have 113.5556m units worth £1.14 each which gives a fund value of £129.4534m. The further investment of £2m buys a further 1.7544m units. Then at time 3 we have 115.3099m units with a fund value of £153.3622m. The core-reading formula then calculates the TWRR as:

(1+i)^3 = (97.2/108)*(129.4534/102.2)*(153.3622/131.4534) = 1.33

as with the unit price only method.

ib) That's correct. E.g a single investment made on 31/12/2017 for a period of one year would have done better invested in A rather than B with a return of 16.7% rather than 6.3% over that period. By considering returns over the whole period we don't necessarily appreciate which investment strategy over that 3 years would have been best ie there may have been times at which we would have performed better in A than B as above.

ii) I think this is solved with my answer to part (i)(a) as well. It's all about the fund value in this case, because the value of the fund at the end is not 133 but 153.36 because the cashflows over the year have purchased extra units and so we've invested more than £100m.

iii) The pattern of the cashflows shows greater investment being made in fund A rather than B early in the period. With fund A's returns being best in the second and third years the pension scheme benefits from investing the money earlier rather than later. On the other hand fund B had it's best returns in the first year, but by investing later on in the 3 year period the trustees do not benefit from the higher return. As MWRR takes into account the timing of the cashflows, and the returns they have therefore benefited from, the MWRR on A is higher than B.

I don't think you've made any real fundamental mistakes here or if you've had it's the same one. Take a look at this question again with a fund value in mind (number of units * unit price) and I think it will start to make more sense.

Hope this helps

This was very helpful,Joe. Sorry about taking a while to get back but I had difficulty in gauging the solution until I practiced it. The calculation for MWRR (and TWRR if we go by book's formula) is quite complex given than we have a total of 2 marks for both funds. Hope that this carries more marks if questioned in future!!