Thursday, December 27, 2012

What to do with the cash that you just created for your client

We often get questions about a problem all asset managers face: a client requests you to sell some of his/her/their securities, to free up cash that they plan to withdraw. Between the time that the cash is created and it's finally taken by the client, it's sitting in the account, impacting the portfolio's return. What options does the manager have? There are a few:
  1. You can leave the cash there and accept the impact. When reporting to the client, you can explain that the cash diluted the return and that you would have invested it if you could have, but at the client's request, it was created for them.
  2. You can move the cash out immediately into a "temporary account." This account would be on YOUR system (i.e., the custodian doesn't know about it), and would segregate the cash you raised from the account and any other cash that may be there (i.e., cash you can invest).
  3. You can move the cash into a different cash "bucket" (or pseudo security), which you would flag as being "unmanaged," so that it isn't included in the returns.
Once the cash is created it's nondiscretionary, is it not? When it was invested it was under your control, but once you create it for the client, you cannot invest it, and so it should arguably be segregated. By moving it into a temporary account, you accomplish this. Also, if you can move it into a different security category and simply give it a different name ("non-discretionary cash") which you've flagged as unmanaged, your return calculation will exclude it.

Some of our clients raise cash for clients who say they'll take it immediately, only to find that the cash is still there weeks (or months) after it was raised. It's unfair for the cash to impact the return when the manager can't invest it. It's just like any other unmanaged or nondiscretionary asset: it should be excluded from the return. Have some other thoughts? Please share them.


  1. I continue to be amazed at the performance world's preoccupation with the effect of frictional cash on investment performance. In their defense, this rather odd source of concern is fueled in large part by the GIPS standard setters, who have made this something of a "cause celebre." Notwithstanding all the smoke and mirrors around this "issue" the fact remains that it's rare to find a client who directs a significant cash withdrawal and then leaves it in the outside manager's account to sit idle. Let's remember that a client usually withdraws only about 5 percent of portfolio value on an annual basis, so this is only about 40 bps in a given month. Even if the portfolio had only 10 managers and the money was taken from a single manager, this would still be less than 5% of that one mandate, and not likely to have a significant effect on performance. (Of course, we must recognize that even a relatively small amount of cash can have a significant effect on performance when market volatility is extraordinarily high.)

    In reality, money is taken out as part of rebalancing the portfolio, and the withdrawal is spread over several managers whose performance has created an unintended overweight relative to target allocation. But the more compelling argument is simply this: clients withdraw money because they need to spend the money, and the typical way that cash is handled is to make the withdrawal and immediately send the funds to the client's cash account (or "sweep" account.) This means that this so-called problem doesn't really exist, unless some basic operations are not properly set up.

    So, for those truly rare times when a) a client withdraws a significant percentage of money from a single manager and b) that money is unfortunately allowed to sit in the fund manager's account... then we can go through whatever gyrations are required to produce a true time-weighted return for that manager. But before doing that, I would correct the operational procedures that allow client money to sit uninvested with fund managers instead of being sent to the client who requested it.

  2. Steve, thanks for your insights. As for these occurrences being "truly rare," I cannot speak; I just know that we DO have clients who occasionally (okay, perhaps "rarely") have clients who ask for $$$ to be created, and then delay taking it. And, regardless of the size of the flow, once the amount is created for the client, it's no longer the manager's to spend, and so becomes non-discretionary. A firm can have a blanket policy that in all cases the money becomes nondiscretionary immediately, or, they could set a threshold. Regardless, this is an option that firms can (and I believe should) take advantage of.

  3. Dave:

    Notwithstanding the frequency of occurrence of idle cash, your suggestion seems quite sound. As you clearly indicate, client directed cash is not discretionary and should not be part of the performance record. Moving this cash to an "unmanaged" bucket seems like the easiest choice, and it's one that I have seen in use quite frequently. It covers a number of realistic situations that fall into the "non-discretionary" category.

    You also bring up an interesting and important issue about not tying out to custodian records and information. This is a necessary "disconnect" since the custodian is reporting on total assets, while the manager is reporting on total assets under his discretion. Two different questions, each handled appropriately.


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