Asset to be avoided?
Despite a widespread flight to cash within the international investment community in periods over the last two years, by and large, pension funds have remained loyal to equities markets. With the FTSE All-World index down 38% since November 2000, many investors have seen cash as a safe haven.
But while higher than usual, cash levels for pension funds have not risen to the extent seen with other investors. Pension funds tend to avoid cash as an asset class, taking the long view instead. UK corporate pension fund AstraZeneca is typical. “We have minimal holdings in cash, and operate to a long-term investment strategy,” a spokeswoman says.
Many individual funds, however, have their own specific reasons for holding more cash than the average pension fund. And even if cash is not held for investment purposes, no fund can operate without a certain level of liquidity. Even frictional cash has to be put to work to earn a return for the pension scheme members. How are pension funds investing their cash?
David Hynes, head of cash management at Gartmore Investment Management, says that cash levels, in this investment environment, are likely to be rising – even for pension funds.
Out of the options available, pension funds are better off holding cash in the form of funds, he says. “We’re trying to encourage them to choose money market funds,” he says. Money market funds offer several advantages over traditional bank deposits, he says, namely diversification, liquidity and higher yields.
Typically, says Hynes, pension funds would leave the cash they hold on call with their custodian bank. But there are hidden dangers in this widely-employed practice.
Most of the custodian banks used by pension funds in the UK are American. Money held by them on call for UK clients is subordinate to similar deposits made in the US, says Hynes. “We’ve been saying to pension funds that you must be aware of that,” he says. It represents a significant extra risk, and there would be no compensation available should the bank be forced to default.”
The highest priority of a pension fund, says Michael Karpik, head of institutional cash at State Street Global Advisors UK, is the preservation of capital. This primary goal needs to be taken into account when making decisions on all types of investment – and that includes cash. Triple ‘A’ ratings are necessary.
“The net asset value should stay at one depending on whatever that unit is – that’s the priority,” he says.
Karpik says pension funds are holding historically high cash levels currently, adding that some of this has to do with reallocation.
He says there is a higher level of risk attached to placing cash on deposit with a bank there is to investing the money in a fund. “The risks are definitely higher whilst the risk is somewhat correlated to the risk of the bank.”
“It’s just prudent investment theory that you would diversify,” he says. “We treat cash as a separate asset class, and therefore we would apply the same principles to cash.”
Despite a strategic asset allocation of just 2% to cash, Italian pension fund Inarcassa has had cash holdings this year which amount to between 3 to 4% of its entire portfolio, says finance director Paolo Tosi. “This year the weight of cash has been high, due to the fall in the stock markets,” he says.
Inarcassa’s in house investment team selects money funds in Europe to place its liquid cash, says Tosi.
The management of cash at the fund is seen as a very important part of the fund’s overall asset allocation. One member of the team is dedicated to finding the best way to invest cash. Maintaining liquidity is important for pension payments, Tosi notes.
Before using money market funds, Inarcassa used to use repos, says Tosi. However, the return on repos was lower than that now achievable on funds. Now, Inarcassa chooses funds that have as their benchmark one-month or three-month Euribor.
Within these funds, typically 80% is investment in products such as cash deposits, and between 15 and 20% is used to increase the return to investors, in instruments such as convertibles. “The aim is to beat the benchmark by 50 basis points,” he says.
Dutch pension fund giant PGGM has a strategic cash allocation of nil. But, says Piet Roelandt, manager of fixed income and treasury at the fund, there are two reasons why in practice there are significant cash holdings at the fund.
One reason for holding cash is pure liquidity, he says. This is held on deposit with a number of different banks. “You can get better prices if you have a number of counterparties, and you have the credit risk,” he says. However, though he agrees diversification is important, cash is primarily left on deposit with its house bank, ABN AMRO.
The other reason for keeping cash stems from PGGM’s decision two years ago to invest heavily in the commodity markets. At that time it opted to commit between 3% and 5% of its total portfolio value of around E47bn to the asset class, and this created the need for a cash position. In order to prevent leverage, the fund has to keep a cash position which is equal in size to the underlying commodities of the derivatives it invests in.
“We have an external manager to manage this cash for us,” says Roelandt. Citigroup AM was selected from four potential managers. The pension fund decided against placing such a large sum on deposit with a number of banks, as it would handle its daily liquidity, saying deposits were not necessarily the best investment instruments from both return and liquidity perspectives.
A fund structure is used, which PGGM says gives it the best of two worlds – it facilitates administration and allows management along customised guidelines, which include minimum credit ratings and concentration limits.
Using funds also has the advantage of offering more liquidity than a deposit would necessarily have. When cash is needed for derivatives settlements, then it can simply be disinvested from the fund at the appropriate time.
Even if cash has proved, retrospectively, to be one of the best investments over the last two years, most managers would be reluctant to hold cash for pure investment purposes. Paradoxically, holding cash is simply too risky for a pension fund manager, says Ian Martin, head of UK institutional sales at Morgan Stanley.
So cash management, he says, tends to be a residual activity, with custodian banks sweeping an account every night. “If you have an equities mandates, then to hold cash would be highly risky,” he says. “If you hold cash and miss the upturn of the market you will be severely punished.” Market timing is very difficult and few seem to get it right, he adds.
“Cash is an extremely risky asset if you have an equity benchmark, because it is totally non-correlated with equities. It is safe in absolute terms, but risky in relative terms,” says Martin. “Most pension fund trustees think about risk in relative terms.”
UK corporate scheme Marconi Pensions is currently considering whether its returns on cash can be improved by pooling the cash elements from its various separately managed investment portfolios. However, the cash element that Marconi Pensions has is now far smaller than was the case two years ago.
As a result of the de-merger of the defence businesses of GEC to BAESYSTEMS in 1999, around half of the then £6bn Marconi pension scheme was transferred to the BAESYSTEMS 2000 Plan. Before this, a large cash holding of up to £200m (E315m) had been actively managed by the in-house team.
As part of the continuing restructuring of the pension scheme investments, certain investment portfolios were taken on by external investment managers. One result of the changes has been that the cash element, which the in house team now manages, is just £10m.
A certain amount of cash is managed alongside securities by the external managers. Lee questions whether investment managers are the best people to manage cash; after all, he says, they were not appointed as cash managers.
However, he points out that unlike custodians, investment managers at least have an incentive to get good returns on cash because it does hit their performance figures.
“I am looking to see whether there are opportunities to pool the cash from the whole portfolio,” says Simon Lee, finance and investment manager of Marconi Pensions. He estimates that the total cash available could add up to around £50m.“There is a potential advantage – we might be able to increase returns. Pooling the cash would give us a bit more control, and we could focus on it more,” he says.
Whichever vehicle Marconi chooses to use for cash management, it is important to minimise the effort required of the in-house team, says Lee. “It is a time-consuming task, and we have all got other things to do which could add more value.”