How do funds handle money in/outflows?

Discussion in 'Order Execution' started by Pekelo, Mar 5, 2008.

  1. Pekelo


    Most funds credit the end of day price for withdrawals/deposits, I assume. But when is the money actually placed into the market (or withdrawn)?
    With this high volatility there can be even 2-3% difference between execution and EOD price, unless the fund tries to execute it as close to the marketclose as they can, but that might be not practical.

    So how does it work?
  2. Funds?
    You're talking about mutual funds, right?

    Hedge funds often provide fixed dates for withdrawal, and you can't know exactly how much you will get.
  3. Pekelo


    Yes, mutual funds, specially indexfunds. Let's say the money is aviable for the fund Monday morning. They gonna credit the account with the EOD price. Depending on when they actually put the money in the market and how much the market moves they can easily make or lose 1-2%...

    I assume it is against regulations that funds would make money this way and not return it to the investors. For a very large fund I guess it is possible that the constant in and out-flow of money evens things out and in the long run there is no extra profit or loss...

    I am just curious how it works...
  4. bt116


    Pretty sure its based on the eod NAV. It's definitely not like an up to the minute sort of thing.
  5. Mutual funds always have some of their money in cash, for withdrawals.

    They just state that withdrawals are made at day end quotes to avoid panic withdrawals and daytraders.

    They haven't really sold exactly at this quote. Remember mutual funds manage large quantities of money, so they can't buy and sell in a minute, like we, retailers do.

    So, they have some amount in cash, say 3%, if today they have withdrawals for 1%, tomorrow they will sell 1% during the day, to have the same 3% cash available.
    Viceversa if deposits exceed withdrawals.
  6. The fund does not make money off the investors this way, the investors own all the securities in the fund. But some "investors" used to make money off others this way.

    In the late trading scandal a few years ago funds were caught allowing favored hedgd funds to trade after the end of the day. The way it is supposed to work is you trade during the day and the price is set at the close. Late trading let the favored traders profit at the expense of existing investors. If the value went up after the close and these funds put cash into the mutual fund at the old price, the cash couldn't be invested right away. So the timers added a cash drag for the long term investors and took part of the gains on the securities they held the prior day. The managers let this happen mostly b/c the timers kept some money in the fund that became part of the fee base.

    The actual losses were usually small but it was a huge trust violation and people pulled billions out of the funds that were caught doing it. I would guess the practice pretty much stopped after that. Lots of lawsuits and regulator investigation too - I know a guy who was an expert witness for one of them.
  7. Pekelo


    I understand that, but there will be always a little or not so little difference between the EOD quote and the money put to work or withdrawn.

    Now I can see that if their traders are good and time the transaction correctly they can make a little extra money on it (buying early with freshly deposited money on a rally day or selling early with withdrawn money on a selloff day) and that extra money could be used for the expenses of the fund instead of for profit...

    To avoid a big difference because it can be negative for them:

    1. They can execute the transaction as close to market close as it is practical.
    2. Average in during the day, this way they gonna at least half the difference.

    But again, they might just execute it anytime because with the constant in and outflow, sometimes they win sometimes they lose but it is a breakeven in the long run, although I think they should still try to time it...
  8. I don't think you're getting it right. It works something like this:

    1) Fund starts the day with the portfolio that was there at the end of yesterday, say $90M stocks + $5M cash. Say there were 10M shares outstanding yesterday, each share is worth $9.50.

    2) Investors send more cash during the day to buy into the fund, say $1M. This stays on the sidelines during the day.

    3) At the end of the day the fund calculates its value ignoring the new $1M cash, say $95M stocks (big up day)+ $5M cash, $100M total. Old investors will get the $5M gain.

    4) They figure out a new share price for all purchases or redemptions. This is value/old shares, or $10. Old shares were 9.50 yesterday and there are 10M, this is how they get the gains for the day.

    5) New shares are issued to the new investors that sent money during the day. $1M came in, shares are $10, so they sell 1000 new shares to the new investors. Now the fund has is worth $101M ($95M stocks, $6M cash) and has 10.001 M shares outstanding.

    6) This repeats on normal days. Then on a special day the fund takes out its fees/expenses for the period. Number of shares don't change, but the value goes down by the amount taken out.

    A bit simplified but those are the basics.

    They might monitor the flows during the day and pre-adjust with the cash they have (from the day before) but they can't get to the new cash until they sell the new shares at the end of the day. If they do what you said and buy early on rally day, this gain goes to the old investors and not fund management.
  9. Pekelo


    Yes but the old investors' old money is already in the market. I am talking about the new investor's new money getting to work and crediting the guy with the EOD price.

    We have an indexfund in the 401K. It is always long of the index. So when there is new money coming in they buy the index, when there is withdraval they have to sell. Now I understand they have 3-5% reserve cash, and usually that handles the money fluctuations. But there will be times when either the withdravals or the deposits are more so they have to move money in and out of the market to keep the same 3-5% reserves and there can be difference between the credited and the actually executed price.
    So how do they avoid not getting a big difference?

    Let's say this is an indexfund with 100 mill AUM. The reserves is 5%. They are long of the index. One day they get a withdrawal request of 8 millions. Obviously the reserve is not enough so they have to sell in the market 3 million worth of the indexstock (actually more because then they would be left without reserves). When do they execute that sell during the day? Are they going to try to time it and guess the best price for the day?
  10. These are managment decisions that probably vary a lot across funds. I think these timing differences just transfer money from the old investors to the new and vice versa. Probably too small too get too worked up about most of the time, just noise compared to their overall volatility - assuming flows are small relative to the size of the fund and as you said they are not all in the same direction. Maybe a more important for index funds b/c they care about low tracking error so much but I don't know anything specific about them.

    How much of a funds assets are in cash will definitely affect reported results over time, especially if changes in their cash position are correlated with market moves, but this is a separate issue that is true even on days when there are no flows.

    One other thing - mutual funds defintely have some breathing room to time things if they really want to and are set up right. If they want to delay stock sales they can use settlement periods that are longer than settlement periods on stock trades or maybe borrow to redeem shares. If they want to "pre-invest" they can use index futures or leverage if they are allowed to. But I think most funds would suck at timing (other than spreading out trades in illiquid assets, if you call that timing) so most should set a reasonable policy and follow it.
    #10     Mar 12, 2008