Having long been sidelined in favour of equities and alternative asset classes, unstable market conditions and new regulations have led to an increased interest in cash. By Lynn Strongin Dodds
Liability-driven investment strategies (LDI), together with the growing use of derivatives and synthetic products, have brought cash management to prominence in Europe. But can investment managers squeeze extra returns from their cash stockpiles?
There is certainly plenty of cash sloshing around. In Europe, assets under management in money market funds soared by over $100bn (e75bn) to $366bn (e275bn) last year. However, it is still a drop in the bucket compared to the US.
, head of the EMEA sales team in the global liquidity business at JP Morgan, notes: “In some ways, cash is the forgotten asset class. Fund managers are focusing more on equities and alternative asset classes and not the residual cash sitting in their portfolios. However, institutional investors are beginning to look at more efficient alternatives.”
, chairman of the Institutional Money Market Funds Association, the trade body representing providers of triple A-rated money market funds and head of cash services at Scottish Widows Investment Partnership, adds: “Cash management still seems unfashionable. Currently, consultants tend to provide advice on asset allocation and regard the cash sitting in portfolios as something that the custodial bank should deal with. Although it is real money that deserves to be actively managed, it does not generate the same excitement as other asset classes such as equities.”
Aiken believes that a combination of factors is forcing institutions to take a harder look at their options. “We are seeing more interest in cash products because of the increase in the use of derivatives by absolute return and LDI strategies.
One key feature of derivatives is that the cash element is not required to purchase the underlying instrument. It is used more as prime collateral, and as a result, the cash needs to be effectively managed.”
The tide could turn further if markets continue to behave erratically. So far, throughout the year stock prices have been on a roller coaster ride although they have surprised analysts by how quickly they recovered their composure after dramatic falls. The uncertainty, though, has been unsettling and it is likely to prompt both institutions and individuals to look for safer havens, such as increasing the cash component in their portfolios.
Industry participants also expect cash’s profile to be raised by the confluence of regulatory changes that have, and are, rolling across the European landscape. For example, the fillip in derivative use in wider and more sophisticated strategies is partly due to changes in the UCITS III regulations which allowed the instruments to be used in UCITS-regulated funds.
Moreover, there is hope that the Basel II rules on capital adequacy requirements could help the cash management cause. Under the current rules, money market funds are treated in the same manner as higher risk equity funds. As a result, banks have preferred to use inter-bank deposits rather than money market funds, which ensured that there was ten times more in the former than the latter, according to figures from Standard & Poor’s.
Under the EU-inspired Capital Requirement Directive, which financial institutions began to implement this past January, triple A-rated money market funds have an identical risk weighting to bank deposits. Providers of cash management products are hoping this could attract a significant increase in institutional investor flows.
In addition, under the EU’s Markets in Financial Instruments Directive (MiFID), due to be introduced in November 2007, those holding money on behalf of clients will, for the first time, be able to use qualifying money market funds, rather than simply rely on bank accounts.
Last but not least, the UK's Financial Services Authority recently announced that banks and building societies that fall inside its liquidity mismatch regime – a measure used to assess the divergence between likely short-term inflows and outflows – can include 95% of the value of holdings within triple-A rated money market funds, putting them on a par with the highest quality of non-government debt securities.
Michael Karpik, senior managing director, US and global cash, at State Street Global Advisors, believes that these regulatory changes should have an overall positive impact on the highly rated cash fund industry. “Among the recent regulatory changes, changes to UCITS will have the most impact on fund managers of these type of funds. For instance, AAA cash funds are now considered eligible assets under UCITS. Also, there are new provisions that allow UCITS funds that generate cash collateral through repo activity to invest that cash into AAA cash funds. Given the yield advantages relative to previous rules allowance, it is important for UCITS fund managers to understand the new regulatory treatment available on AAA cash funds and its complementary impact on their core strategy.”
In the past, fund managers were happy to park their cash with a custodial bank who would put it in an overnight deposit account that earned the interest rate of the day.
Although the industry has developed and become more sophisticated, the type of funds on offer in the cash management space remain the same – triple A money market funds, which remain the favourite, and enhanced cash products. The main appeal of the triple A lies in the fact that these funds are easy to understand, straightforward and provide a certain comfort level. They fit neatly into the plain vanilla money market fund manager’s remit of capital preservation, liquidity and yield –
and in that order.
Their key characteristics are that they operate on a shorter term horizon – typically three months
– and are stamped with a seal of approval from one of the major ratings agencies. Investments are at the conservative end of the spectrum and include a wide range of fairly low-risk securities such as short-term deposits, commercial paper, certificates of deposit and floating rate notes. In addition, most provide same-day liquidity as well as competitive yields – typically London Interbank Bid Rate – compared to a straightforward bank deposit account.
Enhanced funds, on the other hand, are geared for those investors who like to live more on the edge and are happy to take slightly more risk and less liquidity in exchange for a higher return. There is no standard definition of what they may invest in, plus their maturities as well as their credit quality may vary. These funds typically look at the same breadth of investments as triple-A rated money market funds but add a bit of spice by taking a longer term view and going farther down the yield curve – often at the double or single-A rated level.
In addition, according to James Finch, EMEA head of liquidity sales at Barclays Global Investors, many funds are increasingly investing in structured products – such as asset backed securities (ABS) – to provide additional yield to the portfolio. “As clients with more stable cash balances have become comfortable with AAA-rated liquidity funds, they are looking at a wider range of enhanced-yield strategies. We are seeing greater interest from clients in our LIBOR+ fund that predominately invests in ABS.”
Fund managers can typically expect Libor plus 25 for investments with three-month maturities and perhaps Libor plus 50 for those with a longer term timeframe. The concept of risk, though, is a relative term in the enhanced cash sphere. As Peter Knight, global head of liquidity at HSBC Investments, notes: “If pension funds really wanted to take high risks, then they would not go into an enhanced cash fund but emerging markets or other higher yielding asset classes. Cash is used to provide liquidity and to keep the system working.”
Hughes, of JPMorgan, also believes that both the triple-A money market and cash-enhanced products can be used in a complementary fashion. “We are seeing some clients combine an AAA-rated fund for their liquidity needs with an enhanced fund which operates on a longer term investment horizon and provides higher returns. Also, the appetite for these products differs across countries and types of investors. For example, in France, there seems to be a willingness to take more risk in their cash funds. They have a very large market of non-rated funds that go beyond the typical cash fund.”
Looking ahead, Phil Barleggs, head of fixed income product management at Insight Investment, believes that products will become more sophisticated as institutional investors continue to embrace LDI solutions.
“We expect to see enhanced-cash funds increasingly being used as part of an absolute return type of investment approach.
For example, we are seeing more interest in our bonds-plus fund product which targets absolute returns of 2% per annum above a cash benchmark. It invests in a broad variety of bond related assets but the objective is still to exceed cash returns rather than a particular bond index.”
© fe July 2007