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Cash Flows

Firms must use time-weighted rates of return that adjust for cash flows, where a "cash flow" is an external flow of cash and/or securities (capital additions or withdrawals) that is client initiated.

Time-Weighted Return prior to 1 January 2010 provided the calculation method chosen represents returns fairly, is not misleading, and is applied consistently.

Modified Dietz

Modified Dietz suffers most when a combination of the following conditions exists:

• One or more large cash flows occur.
• Cash flows occur during periods of high market volatility.

The actual valuation of the position, account or portfolio each time there is an external cash flow will result in the most accurate time-weighted rate of return calculation.

GIPS Q & A

Q: The GIPS standards state that for periods beginning 1 January 2010, firms must value portfolios on the date of all large external cash flows. We use the Modified Dietz method. Does this mean the Modified Dietz method will no longer be allowed to calculate monthly portfolio returns and we must value portfolios daily beginning 1 January 2010?

A: If there are no large external cash flows during the period, no additional revaluation of the portfolio would be required and the use of the Modified Dietz method (or another method that daily weights cash flows) to calculate the monthly portfolio return would be acceptable. The Modified Dietz method can also continue to be used when calculating partial monthly period returns prior to and after a large external cash flow. This change does not require a firm to value all portfolios on a daily basis. Instead, a firm will need to revalue a portfolio at the time of a large external cash flow for periods beginning 1 January 2010.

For example, if a firm utilizes the Modified Dietz methodology to calculate portfolio returns on a monthly basis and one of the external cash flows during the period is “large”, the firm would revalue that portfolio at the time of the large external cash flow in accordance with its cash flow policies and procedures. The firm would then calculate the portfolio return for the partial periods before and after the large external cash flow using the Modified Dietz methodology for the partial period, and geometrically link these partial period returns to calculate the portfolio’s monthly return.

Standard 2.A.2: “Time-weighted rates of return that adjust for cash flows must be used. Periodic returns must be geometrically linked."

Q: The GIPS standards state that for periods beginning 1 January 2010, firms must value portfolios on the date of all large external cash flows. We presently assume all cash flows take place as of the beginning of the day and so the revaluation is done at the close of the business day prior to the large external cash flow. Does this mean our policy is no longer acceptable and we must revalue the portfolios with large external cash flows on the exact date of the cash flow for periods beginning 1 January 2010?

A: No, the change in the provision noted above would not require you to change your current policy for periods beginning 1 January 2010. The intent of the provision is to require firms to revalue portfolios at the time of all large external cash flows and so revaluing portfolios as of the close of the business day prior to the large external cash flow will continue to be acceptable if cash flows are assumed to take place at the beginning of the day.

Q: The GIPS standards state that for periods beginning 1 January 2005, firms must use approximated rates of return that adjust for daily-weighted external cash flows and that for periods beginning 1 January 2010, firms must value portfolios on the date of all large external cash flows. Given the new 2010 requirement referenced above, is the 2005 requirement to daily weight external cash flows still effective for periods beginning 1 January 2010? We calculate our portfolio returns on a monthly basis.

A: The 2005 requirement referenced above is not being eliminated. If the firm calculates performance monthly and there are no large external cash flows during the month, the firm must continue to use a monthly rate of return methodology, such as Modified Dietz, which adjusts for external cash flows on a daily-weighted basis. Effective for periods beginning 1 January 2010, if a large cash flow takes place during the month, the firm would revalue the portfolio at the time of the large external cash flow and calculate performance for the partial periods before and after the large external cash flow using a methodology that adjusts for daily-weighted external cash flows.

For example, if there are numerous external cash flows during the month with a single "large" external cash flow in the month, the firm would compute the portfolio return for the partial monthly periods before and after the large external cash flow using a rate of return methodology, such as Modified Dietz, which adjusts for the other (non large) external cash flows on a daily-weighted basis. The firm would then geometrically link these two partial period returns to calculate the portfolio's monthly time-weighted return.

Q: We are in the process of establishing our significant cash flow and large cash flow levels for each composite. We understand that establishing a significant cash flow policy is optional whereas for periods beginning on or after 1 January 2010, firms must define the level of large cash flow for each composite to determine when portfolios in a composite must be valued. Can the level used to define large cash flows and significant cash flows be the same? If not, does the level established for significant cash flows need to be greater than the level used for large cash flows?

A: The GIPS standards define 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. Firms must define large cash flow levels for each composite to determine when portfolios in that composite must be valued. Portfolios that experience a large cash flow remain in the composite. The determination of the large cash flow level may be influenced by a variety of factors such as the nature of the strategy, historical and expected volatility of the strategy, and the targeted cash level of the strategy.

The GIPS standards define 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. Firms that choose to adopt a significant cash flow policy for certain composites must define the significant cash flow level on a composite-specific basis. Portfolios that subsequently experience a significant cash flow are then temporarily removed from the composite. The determination of the significant cash flow level may be influenced by a variety of factors such as market liquidity and by the trading capabilities of the investment manager.

It is not expected that the level used to define large cash flows and significant cash flows will be the same. It is expected that the level used to define large cash flows will be less than the level established for significant cash flows, as the cash flow amount that would cause a portfolio to need to be valued because performance may be distorted typically does not rise to the level that disrupts the implementation of the investment strategy.