The Global Investment Performance Standards (GIPS(R)) has certain rules regarding significant and large cash flows. Because the words, “significant” and “large” can be considered synonymous, confusion often results. This post will touch on this a bit, with more to appear in this month’s newsletter.

Significant and large cash flows

There are big differences between what is meant by significant and large cash flows, and the rules surrounding them are also quite different.

• Significant cash flows: this is an option, and there’s a guidance statement that provides much help in understanding what it means and the rules behind it. This option allows firms to temporarily remove accounts from composites, when cash flows are of such a size that, in order to raise the required funds (for an outflow) or to invest the new money (for an inflow), such time is needed that would result in the account not being representative of the strategy. Therefore, the firm will remove the account so they can invest the new money or raise the funds for the client. Firms that invest in less liquid assets would be more inclined to employ this option, though it’s available to any GIPS compliant firm. Also, firms may specify its employment differently from one composite to another (e.g., having different thresholds as well as whether to employ it at all). When using this option, additional disclosures are required within the firm’s composite presentations (see ¶ I.4.A.32; Global Investment Performance Standards; 2010 edition)
• Large cash flows: this is a requirement, when firms are calculating account returns on a monthly basis. Its purpose is to improve the accuracy of the return. We recognize that with monthly time-weighted return methods (e.g., Modified Dietz and Modified BAI), large flows can distort the return, making it less accurate. Therefore, to improve accuracy, firms will revalue the portfolio when a large cash flow occurs, and calculate performance from the start of the period until the date of the flow, and then from the date of the flow to the end of the month (or, until yet another large flow occurs, if one does within the same month). What’s a reasonable threshold for large? Well, I’d say the maximum limit should be 10%, which seems to be a very standard threshold, though a lower level (e.g., 5%) would be better. Note that if the firm calculates performance on a daily basis, this rule doesn’t technically apply, since there will be no need to test for the size of flows.

Netting flows: when they make sense

Occasionally, I’ll find that clients will “net” their cash flows to decide if the flow is “large” or “significant.”

I think it’s okay to net for significant. For example,

1. Let’s say that if a client adds $20,000 to a $100,000 portfolio. The significant cash flow limit is 20%, thus this is a “significant cash flow.” However, if a few days later the client withdraws $5,000, so the net cash flow amount is only $15,000 ($20,000 + (-$5,000)), which is below the threshold. Netting flows would cause the account to remain in the composite.
2. A problem with netting, however, is that the time between flows may be such that netting causes an account to stay in a composite when it should be removed. For example, let’s say that we have the scenario just mentioned, but the $20,000 occurs on the 2nd of the month, while the withdrawal of $5,000 takes place on the 28th. Chances are, the account has been non-representative of the composite for much of the month, due to the $20,000 flow; however, by netting, we’re going to leave it in; arguably, we shouldn’t.
3. If an account is valued at $1,000,000 at the start of the month, and the client adds $100,000 on the 5th and then another $125,000 on the 10th, the total contribution is $225,000. If their significant cash flow threshold is 20%, then the total exceeds the threshold, which would mean the account needs to be removed from the composite.

Most firms don’t net, but it is an option.

As for “large” cash flows, netting is permitted, though I question its appropriateness.

1. A client adds $20,000 to a $100,000 portfolio; their “large cash flow” threshold is 10 percent. Thus, the flow exceeds this level. However, a few days later the client withdraws $15,000, so the net flow is only $5,000 ($20,000 + (-$15,000)), which is less than the 10% level. In reality, we should revalue for the $20,000 flow; in addition, we should revalue for the $15,000 withdrawal. Large flows distort performance; netting them doesn’t remove the distortion. But, firms are permitted to “aggregate” these flows.
2. A client who has a $1,000,000 portfolio adds $50,000, which is just 5% of the portfolio. A few days later, an additional $50,000 is added, which results in a total net flow of $100,000, which is 10% of the starting value. Do we revalue? I would argue that we shouldn’t, but you are permitted to aggregate the flows, which would cause a revaluation. You’d have to decide when to do this, whether it would be on both dates or a day in between them or perhaps the date of the most recent flow. It’s my believe that we deal with individual flows for the large cash flow option.

In general, I think that aggregating flows in order to do a “large cash flow analysis” creates an unnecessary level of complexity. I believe treating each flow independently is most appropriate. But, perhaps I can be persuaded that I’m incorrect.

Your policies & procedures need to reflect your rules regarding large cash flows; and, if you employ significant, you need to address this, too!

There is so much confusion about significant and large cash flows; it’s probably one of the most confusing aspects of the Standards. I’ll have more to say in the newsletter piece.