Large vs Significant Cash Flows – What’s the difference?
Sean P. Gilligan, CFA, CPA, CIPM & Sara Celapino
August 10, 2022
Cash flows are frequently mentioned throughout the GIPS standards, and there can understandably be confusion around the terms “large cash flow” versus “significant cash flow.” While these terms sound very similar, they refer to different concepts and each play an important role in performance calculations and composite construction for firms that comply with the GIPS standards. It is also important to note that although they are called “cash” flows, this term refers to any type of external capital flow (cash or investments) entering or exiting the portfolio.
The key difference to remember is that the “large” cash flow requirements are focused on ensuring that the methodology used to calculate time-weighted returns (TWRs) is as accurate as possible. Conversely, the guidance relating to “significant” cash flows is concerned with a portfolio manager’s ability to fully implement the intended strategy. We discuss these differences in more detail below.
What are Large Cash Flows?
A main consideration for portfolio-level calculations is the treatment of external cash flows. As of the start of 2010, the GIPS standards require firms to value non-private market investment portfolios at the time of each large cash flow, in addition to the last business day of the month. The purpose of this requirement is focused on the accuracy of the performance calculations. Methodologies that daily-weight external cash flows based on the amount of time they were in the portfolio, such as Modified Dietz, begin to lose their accuracy as the size of the cash flow increases, especially during volatile market periods.
What is considered “large” is up to each firm to define for themselves. Historically, the default setting for many portfolio accounting systems was set to revalue for cash flows that are 10% of the portfolio’s value or larger. Many systems now revalue portfolios daily, which means they essentially have a threshold of 0%. What is most important is to choose a threshold that provides accurate results, even if you’re not revaluing every day or for each cash flow. While 10% is still the most common threshold for firms that do not revalue for all cash flows, some firms set thresholds as high as 20%; however, anything higher than 20% is uncommon.
Firms must define the appropriate large cash flow threshold at the composite-level with consideration for factors such as the nature of the strategy, its volatility, and its targeted cash level. Some portfolio accounting systems have the option of implementing a large cash flow policy at the asset-class-level, although it’s most common to see large cash flows defined in terms of a percentage of overall portfolio assets.
While the GIPS standards allow some flexibility in how TWRs are calculated, the methodology used must meet certain criteria. When calculating TWRs monthly, firms must calculate sub-period returns at the time of all large cash flows and geometrically link the sub-period returns. The Modified Dietz method, which weights each external cash flow by the amount of time it is held in the portfolio, is a common methodology used in calculating a TWR when cash flows do not exceed the threshold set to define “large” cash flows. Details of the calculation methodology used for portfolio-level calculations must be documented in a firm’s GIPS policies and procedures (GIPS P&P).
Significant Cash Flows
While the requirements relating to “large” cash flows are focused on the accuracy of performance calculations, the purpose of establishing policies relating to “significant” cash flows are designed to help identify when portfolios should be temporarily removed from composites. The GIPS standards recognize that very large external flows of cash or investments can significantly impair a firm’s ability to implement a portfolio’s intended strategy, causing the portfolio’s performance to deviate from that of the composite. Firms have the option to establish a significant cash flow policy that temporarily removes a portfolio from the composite to avoid the disruptive effects of significant cash flows.
Firms adopting a significant cash flow policy must define “significant” at the composite-level, and the policy may differ between composites. Firms should determine the threshold by considering factors such as the liquidity of the strategy’s investments and the time it takes the firm to invest new money or raise funds for a client-requested distribution. The significant cash flow threshold may be based on a specific dollar amount, but it is more commonly based on a percentage of the portfolio’s market value. Firms may define a significant cash flow as a single flow or as an aggregation of flows within a stated period.
The policy may only be applied prospectively. Firms should consider whether a significant cash flow policy is needed during the initial construction of a composite, although the policy can be changed going forward with proper documentation. The concept of a significant cash flow applies only to composites presenting TWRs and does not apply to pooled funds presented in GIPS Pooled Fund Reports. Details on a composite’s significant cash flow policy must be documented in the firm’s GIPS P&P, as well as disclosed in the composite’s GIPS Report.
Summary of Key Differences
Large Cash Flow Policy
- Requirement for firms calculating returns monthly
- Portfolios experiencing a large cash flow remain in the composite
- Purpose is to improve the mathematical accuracy of portfolio-level calculations
Significant Cash Flow Policy
- Optional policy
- Portfolios experiencing a significant cash flow are removed from the composite for a specified period
- Purpose is to ensure composite-level performance results are not distorted by very large cash flows that were not controlled by the portfolio manager
A firm can establish both a large cash flow policy and a significant cash flow policy. While these two thresholds are determined independently from one another, it is generally expected that the significant cash flow threshold is higher than the large cash flow threshold. Firms are not allowed to set a significant cash flow threshold equal to or lower than the large cash flow threshold for the purpose of avoiding revaluing portfolios.
If you need assistance calculating performance or deciding which GIPS policies make the most sense for your unique strategies, please contact us to find out how we can help.