Netting same day flows...expanded commentary

Earlier this month I commented briefly on the question of netting same day cash flows. And, as promised, I expanded this topic in this month's newsletter.

I must confess that the analysis helped me gain greater appreciation for the proper treatment of cash flow timing. Our training classes include examples which dramatically show how mistakes in timing can lead to huge errors. This month's newsletter provides a similar, though different perspective on this topic.

A lot of times it's these small details that can lead to huge errors; and even when the errors aren't "huge," they can be still cause problems. In fact, it's probably the not-so-huge errors that are more problematic, because they're more likely not to be discovered.

Have thoughts, comments, insights, or stories to share? Please chime in!

Treatment of reinvestment of income in returns

A colleague sent us a note recently inquiring about the proper treatment of accounts that have dividends reinvested; that is, how the flows are to be handled from a return perspective. The essential question is "should the money flowing into the account, to purchase additional shares, be treated as a cash flow?" And the answer is a conditional one:

• If you treated the dividend that flowed out of the account as a cash flow, then yes
• If you didn't treat the divided that flowed out as a cash flow, then no.

We essentially want our flows to cancel each other out, as the dividend's impact should be kept within the account, and the manager should benefit from it. We cannot treat only the money coming in as a flow because then the manager wouldn't get credit for creating it.

Significant cash flows ... so easy to get wrong

Perhaps it's partly because "significant" and "large" can be viewed synonymously that we find confusion regarding how firms can handle these within GIPS(R). One of our clients was clearly thinking that "significant" means the same as "large" when it comes to the standards, but it doesn't. Significant flows deal with the opportunity to temporarily remove portfolios from composites in the event of large (sorry, I mean significant) cash flows...the idea being that all of a sudden you get a lot of cash and it may take time to invest it, so remove the account while you get the cash invested. On the other hand, effective 1/1/10, GIPS compliant firms will be required to revalue portfolios for large flows.

I'm at an outsourcing client who has a client who NETS cash flows during the month to determine if the account should be removed. NETS cash flows? And why do they do this??? Hopefully we'll find out, but let's think about this.

Their level to remove the account is >25% of the beginning market value. And so, we start with $1 million. On August 3 a $300,000 contribution is made. Then, on August 24, the account withdraws $250,000. Net = 300,000-250,000=5,000; 50,000/1,000,000 < 25%; therefore, don't remove the account. WHAT???

If the firm actually wishes to take advantage of the optional significant cash flow provision, they should have removed the account because of the August 3rd contribution (because presumably there's a bunch of cash they need to get invested). The fact that a few weeks later the client decided to withdraw funds has nothing to do with the earlier flow. In my opinion, they are confused!

Also, in my opinion: this is (a) wrong and (b) shouldn't be permitted by the firm's verifier.

Why I don't like mid-day cash flows

I'm reviewing a client's calculation process and learned that they previously employed a mid-day approach: note that they calculate returns daily but simply assumed that the flows occurred mid-day. I have never liked mid-day for cash flows. Why?

As you may recall, GIPS(R) mandates that effective 1 January 2010 compliant firms revalue portfolios at the time of large cash flows ... who is going to revalue their portfolio mid-day? Firms revalue at the start and/or end of the day, but not mid-day. Using the start or end of day approach for cash flows yields an EXACT return. However, if you use the mid-day approach, you're actually using an approximation approach to derive your return. One might argue that mid-day is good if you can't decide between start and end ... sorry, but I don't buy it.

Most firms use either start or end of day weighting for cash flows: to me this is the way to go. In fact, we're seeing an increasing number move to start for in-flows and end for outflows, which seems to work best.