Wednesday, June 3, 2009

January 1, 2010 isn't far away (large cash flows)

While many GIPS-compliant firms are preparing for January 2011, they also need to be aware of what's in store for them in just seven months.

Most firms are aware of the new requirement to revalue portfolios for large cash flows (Para. 2.A.2.b.). But, have they looked at the broader picture? Let's take the case of a wrap fee manager who relies upon their program sponsors for the returns they use for GIPS purposes. Have they validated that these entities have adopted a calculation methodology that will comply with these new requirements? If not, there's not much time to get this addressed.

The standards for wrap fee allow managers to either use their own returns or rely on the sponsor, provided the sponsor adheres to the standards. This is a test case to ensure this is being done.

If you're involved with wrap fee programs and rely on your sponsors, confirm that the returns will meet these requirements...the sooner, the better!


  1. It is unfortunate that so many fundamental statements are made and then accepted as true even though no evidence to support these statements is ever offered . One such statement is: "More frequent calculations lead to greater accuracy." Another is: "Large cash flows occur frequently." Where is the evidence that either of these statements is true? What IS true is that the result of believing these unproven statements has increased the cost and the complexity of performance reporting for everyone, and there has been no demonstrated improvement in results. Let's examine the issue of large cash flows.

    Anyone with experience dealing with investments and with clients knows that large cash flows are an unusual event. While we may not know WHEN they may occur, we do know that they do not OFTEN occur. In reality, managers are hired for individual asset mandates within an overall portfolio and they are expected to remain in the portfolio for years. Meanwhile, clients make relatively small withdrawals and contributions to the overall portfolio. For example, many clients spend about 5% from their portfolios annually. Even if the entire amount were to be spent in a single month, this would still be a small withdrawal from any single manager, since the amount is usually withdrawn as part of an overall rebalancing effort that goes across many of the managers. Likewise, most plans don't contribute anything remotely nearing 10% in any single time period. (Yes, I know that a "significant" cash flow can involve less than 10% when volatility is high - thank you Captain Obvious - let's not split hairs.)

    What we need are standards that take care of the USUAL things that have a large IMPACT on results, not standards that handcuff everyone because an UNUSUAL thing MIGHT occur SOMETIMES and make a difference in a MINORITY of cases. If we all had unlimited staffing, budgets and time we might be able to deal with such fear-based requirements. However, since we are living in the real world, we would be better off if the standard setters had to PROVE that their new requirements were meeting a REAL need before they were allowed to make such burdensome new regulations.

    We need to require standard setters to prove the relevance of their standards updates by performing a cost-benefit analysis. Remember that it is YOUR firm's money that they are spending when they increase your cost of doing business.

  2. As usual, I find myself in general agreement with my friend, Steve Campisi. On one point, the frequency of large cash flows, I believe that we need to be mindful that even though they may not occur with great regularity, when they do happen their impact on the accuracy of the result obtained from an approximation method (e.g., Modified Dietz), is such that improvement is probably justified. I’ll have more to say to this below.

    I particularly love Steve’s point that those who establish the rules should have empirical evidence to justify the cost, complexity, and in essence, intrusion, they make on a firm’s practice.

    This point made me think immediately of the proposed change to require daily treatment of cash flows for private equity. Okay, so what does this mean? Recall that GIPS requires private equity managers to use since-inception IRR (not TWRR) because these managers control the cash flows. At present, managers can treat the flows on either a daily basis or by aggregating the flows to a single day in the month. What’s the difference? Well, the daily approach will make the equation more complex and may increase the likelihood of not finding a solution. My question has been: is there evidence that this change significantly improves the accuracy of the result, such that the added complexity is justified? I haven’t seen any. And, I would hope that some justification could be provided before requiring this change.

    While I have evidence in a test (laboratory) environment that justifies the requirement to revalue portfolios on a daily basis, I haven’t seen true market-driven, real-life, empirical evidence and so Steve’s point here seems appropriate and worthy of reflection. Likewise, the same can be said for the proposed change for the IRR.

    Many of the proposed changes add complexity and cost to compliance, which will no doubt cause a lot of firms to contemplate whether or not they can continue to comply. Something to consider, yes?


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