What Are Flows in the Asset Management Industry?
Flows, also referred to as “External Flows” or “Cash Flows,” are when an investor contributes additional funds to the portfolio or takes funds away from the portfolio.
This is key to understanding performance, since your portfolio can change in value due to 2 reasons:
1) Gains/losses which represent your return, and
2) Flows, which is not part of your return.
What Are “Cash Flows” Comprised Of?
Even though the asset management industry sometimes refers to flows as “cash flows,” they are actually not always cash. You can actually give an investment manager additional money via the following:
* 100% cash
* 100% securities (sometimes called transfer in-kind, redemption in-kind, free deliver, or free receive)
* A combination of cash and securities (also called a transfer in-kind, redemption in-kind)
Why Are Cash Flows Comprised Of Securities Instead Of Cash?
One situation is when a client is an individual. They they may want to hold the securities for tax purposes or for an emotional attachment (my grandpa gave me that stock when I was a young lad..).
The other situation can apply to individuals or institutions. Sometimes, the portfolio manager agrees with what you are holding and so they may want to keep some or all of the securities. Therefore, the securities are transferred to the new manager to avoid unnecessary transaction costs incurred by selling and buying back the same securities.
Why Are Flows Important When It Comes to Calculating a Return?
Flows are very important when calculating a return because they are used to determine your gain/loss and what your “investment basis” was. Let’s look at one example—calculating a time-weighted return for a day.
You start with $100,000 and you contribute (add) another $20,000 during the day. You end with $124,000.
Reason #1 for the importance of flows: Determining your gain or loss.
Your portfolio increased $24,000, but $20,000 of that was due to a contribution. So, $4,000 was due to growth in investments (also called a profit or gain). This $4,000 will be used to calculate a return for the day.
This shows why it’s important to know what the cash flows were in addition to the changes in market value. Without cash flows, you can’t distinguish whether increases or decreases to a market value are due to investment gains or outside contributions or withdrawals.
Reason #2 for the importance of flows: Determining your investment basis.
Your gain was $4,000. Was that $4,000 earned on the $100,000 starting value? Or was it earned on the full $120,000, which is the starting value + $20,000 you added during the day? Well, that will depend on the flow policy you use, which we will discuss further below.
Please note the above gain/loss and investment basis are used for time-weighted return calculations. Another type of return that uses cash flows in a different way is the Internal Rate of Return (IRR), which is discussed in detail on another page.
What Is a Flow Weighting Policy?
A flow weighting policy is an assumption about the time of day or month the flow came into the portfolio. This is important when calculating a return.
Let’s use a daily return calculation as an example. We will use the same numbers as above.
You start with $100,000 and you end with $124,000. You contributed 20,000 during the period, so $4,000 is due to growth in investments (also called a profit). What is your return?
* Assumption #1: Beginning of Day Flow – We assume the $20,000 flow was received at the beginning of the day so the $4,000 was earned on $120,000
Return = 4,000 / (100,000 + 20,000) = 3.33%
*Assumption #2: Middle of Day Flow – We assume the $20,000 flow was received at the middle of the day so the $4,000 was earned on $110,000
Return = 4,000 / [100,000 + (20,000/2)] = 3.64%
* Assumption #3: End of Day Flow – We assume the $20,000 flow was received at the end of the day so the $4,000 was earned on $100,000
Return = 4,000 / 100,000 = 4.00%
Conclusion: Your return changes based on when you assume the flow comes in.
Because accounting and performance systems are unable to perfectly match the timing of the flow in the return calculation to the receipt of the money, investment managers typically have a policy that states what their assumption is (e.g., all flows are treated as EOD).
Is There Any Difference Between Flow Weighting Policies for Cash and Securities?
Well, I am glad you asked! Or wait…I asked!
The answer is…yes!
For cash, you can assume BOD, MOD, or EOD with little consideration of how the flow is put into the accounting system. However, with securities, there is an additional factor—the price used to value the flow.
For performance purposes, the price you use to value the securities coming in has to match the timing of your flow policy for those security flows.
* If the pricing of the securities are priced at the end of the day, then the flows must be reflected at the end of day on performance.
*If the pricing of the securities are priced as of prior end of day, then the flows must be reflected as beginning of day on performance.
Let’s show you why with the following example:
Your investment manager owns 100 shares of stock A, and you have another 100 shares of stock A you would like to send her from another account.
Today, it closes at $104 and yesterday it closed at $100. That is a return of $4 / $100 = 4%.
There are two ways to correctly handle this:
1. Treat the shares as coming in at the beginning of the day, and use the values from the prior end of day
In the case of the beginning of day calculation, you are assuming the flow occurred at the beginning of the day (which is the same as prior end of day). That means you started the day with the following:
a) 100 shares that was already in the account, plus
b) 100 shares that were received at the beginning of the day
So you are starting with 200 shares, and the beginning value would be 200 x $100 = $20,000. At the end of the day, the 200 shares would be valued at 200 x $104 = $20,800.
Your return would be $800 / $20,000 = 4%.
For those who are more visual:
2. Treat the shares as coming in at the end of the day today, and use the values from the end of the day today
In the case of the end of day calculation, you are assuming that the flow happens at the end of the day, and that you only started the day with 100 shares. That means you started the day with the following:
a) 100 shares that was already in the account
The beginning value would be 100 shares x $100 = $10,000. At the end of the day, the 100 shares would be valued at 100 x $104 = $10,400. Then you would receive the flow of the additional $10,400 in shares.
Your return would be $400 / $10,000 = 4%.
Note: At the end of the day, your ending value would actually be $20,800, but then you remove the $10,400 flow to get the $400 profit used above. For those who are more visual:
The only drawback of method #2, is that it becomes a bit more complicated if you sell the shares before the end of the day. Therefore, my preference is method #1.
If you were to not align the flow pricing to the flow policy, here are the results:
3. Treat the shares as coming in at the end of the day, and use the values from the prior end of day
The starting value would be $10,000 and the gain/loss would be incorrectly $800, for an incorrect 8% return.
4. Treat the shares as coming in at the beginning of the day, and use the values from the end of day today
This would actually affect the gain/loss from the prior day.
I hope this has been helpful! Let me know your thoughts!
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