It is common for asset managers to be confused by two terms used in the Global Investment Performance Standards (GIPS®) that include the words “cash flows.” While they are similar, these two terms have very different meanings and implications.
The GIPS standards define:
- a large cash flow as the level at which the firm determines that an external cash flow may distort performance if the portfolio is not valued; and
- a significant cash flow as the level at which the firm determines that a client-directed external cash flow may temporarily prevent the firm from implementing the composite strategy, thereby causing the portfolio to no longer be representative of the composite strategy.
|Large Cash Flows||Significant Cash Flows|
The concept of large cash flows relates strictly to how a portfolio return is calculated when a daily calculation is NOT used. A determination must be made as to what size of external flow would distort the portfolio’s monthly return if the portfolio is not revalued mid-month. These mid-month revaluations more accurately calculate a time weighted return. Asset managers must define what a large cash flow is for each composite. Implementing the policy means that any flow equal to or greater than the established level, or threshold, will trigger the portfolio’s revaluation of the flow. Asset managers will need to calculate sub-period returns within the months that have revaluations due to large cash flows. The monthly return calculation will then be calculated by linking sub-period returns. An example is as follows:
|Date||Amount||Calculations||Return||Converted Return||Linked Monthly Return|
|1/31||Beginning value||100,000||Sub-period 1 numerator||(102,000-100,000)|
|2/14||Mid-month value||102,000||Sub-period 1 denominator||100,000||2.00%||1.0200|
|2/15||Large cash flow||26,000||Sub-period 2 numerator||(131,000-128,000)|
|2/28||Ending value||131,000||Sub-period 2 denominator||128,000||2.34%||1.0234|
Large cash flow thresholds can vary by composite, but once established the policy must be applied on a consistent basis. Asset managers should consider several aspects of the strategy before determining levels including asset class, anticipated cash normal levels, and volatility of the strategy. While the terminology references “cash”, the GIPS standards define an external cash flow as capital (cash or investments) that enters or exits a portfolio. Therefore, asset managers must consider all cash and in-kind securities external contributions to or withdrawals from a portfolio in their calculation of “large”. The threshold must be set as the cash or asset flow’s value as a percentage of either the portfolio’s total assets or the composite’s total assets.
Asset managers must:
- set levels that are reasonable; and
- determine if a large cash flow is a single external cash flow or an aggregate of a number of external cash flows within a stated period of time.
Asset managers are prohibited from choosing a high level strictly for the purpose of avoiding frequent mid-month valuations.
The good news is that most performance systems have this calculation capability. Once an asset manager determines the appropriate threshold, setting those levels by composite is quite easy.
The concept of significant cash flows relates to the level at which a client-directed external cash flow impacts the asset manager’s ability to fully implement their strategy. Significant cash flow policies are optional and can be established for one, several, or all composites. The composite-specific significant cash flow level set by an asset manager must represent the asset manager’s estimate as to the level at which an external cash flow would impact the asset manager’s ability to fully implement its investment strategy.
If a significant cash flow policy is adopted, there are several requirements:
- Significant cash flow levels on a composite-specific basis must be defined.
- How the level of significance is defined must be documented. It may be based on the relative size (as a percentage) of the flow to the portfolio’s market value or based on a specific dollar amount.
- The policy must be applied consistently – all portfolios that experience a significant cash flow must be temporarily removed from the composite.
- The policy must only be applied prospectively.
- Additional disclosures about the policy must be made within the compliant presentation for those composites that have established a significant cash flow policy.
- Documentation and support for each time a portfolio is temporarily removed from a composite due to a significant cash flow must be maintained.
For each composite, asset managers should consider characteristics of the strategy before determining the significant cash flow level, including the speed at which a particular asset class can be invested and the normal liquidity of the asset class.
Asset managers should not opt for significant cash flow policies to circumvent revaluing portfolios mid-month as part of their large cash flow policy or as a way to remove portfolios that temporarily perform differently from the rest of the composite.
Remember: establishing levels for the large cash flow policy and the significant cash flow policy should be done separately. The level for when a portfolio should be revalued mid-month will most likely be lower than the level for when an external flow would render a portfolio non-discretionary.