Cash – a very expensive asset to hold
In 1983, we pioneered active cash management in the US. In response to companies like The Walt Disney Company that had large sums of cash set aside for future projects, we were able to demonstrate the benefits of active short-term asset management. Since then we have developed global cash portfolios, as well as money market funds and government investment pools. Of the $28bn (E26.9bn) we manage today, $8.5bn is in short-duration fixed income strategies for public funds, pension plans and corporate clients such as Amazon.com.
In addition to our short duration capabilities, we have developed expertise in various global strategies along the yield curve. We began offering non-dollar strategies to our clients in 1986, and now manage more than $6bn in global portfolios. This knowledge of non-US markets coupled with our long history of managing short-duration strategies enables us to manage both sterling- and euro-based cash portfolios.
Our cash management investment philosophy remains simple – to maintain preservation of principal while providing a competitive return net of fees relative to short-term alternatives. Portfolios are invested in highly liquid, investment-grade securities to accommodate daily cash flows and structured to have an average credit quality of triple A. We use most sectors of the money market, including commercial paper, certificates of deposit, floating rate notes, repurchase agreements and government securities. In some cases, a specific fund might also permit the use of asset-backed securities, collateralised mortgage obligations and short-term corporate notes. We strive for portfolio diversification, not allowing sector or industry concentrations to exceed 20% of the portfolio and limit individual issuer positions to no more than 2% per name.
We recognise that cash is a very expensive asset to hold and, therefore, we look to add value by investing in longer maturity securities in our enhanced cash portfolios, generally no more than two to three years. By investing in these longer maturities, we benefit from the “roll-down effect”, which provides excess returns in our portfolios. What this means is that during a steep yield curve environment, a bond approaching maturity will roll down to a lower yield and a higher price. Historically, the steepest part of the yield curve has been the one to three year maturity range. By taking advantage of opportunities along this portion of the curve, we can provide the best risk/reward trade-offs for our clients.
Sector management is a contributing factor in the performance of our portfolios. In US portfolios, the strategic use of sector strategies can add additional 30–40 basis points of return. We manage each client portfolio in accordance with their specific guidelines regarding allowable sector quality, diversification, and concentration limits. As permitted by client investment guidelines, our portfolios hold diversified positions in sectors that apply to the short part of the yield curve including non-government sectors such as asset-backed securities, corporate bonds, CMO/mortgage pass-throughs, and international securities.
Our assessment of risk is the most critical component in our investment process. We quantify and mitigate the exposure of portfolios to factors that may have a negative impact on performance. In addition to the traditional use of such measures as duration to quantify portfolio risk, our analysis involves stress-testing the portfolios against factors such as changes in interest rates, yield curve shifts, corporate spreads, implied volatilities and liquidity. This analysis allows us to construct and maintain portfolios that are appropriate relative to our clients’ objectives and constraints.
Since 1994, structure risk has surfaced in these strategies, thus increasing the importance of stress-testing to understand the liquidity of these instruments. With the development of the derivative markets and structured products, it is not uncommon to have triple A-rated securities that possess significant cash flow risks and the added downside of limited liquidity. As a result, we now spend a considerable amount of time and resources analysing bond structures and more subjective issues, such as liquidity, that go far beyond the more traditional credit process.
Due to the recent growth of non-government bond issuance in Europe, we can add value to short duration portfolios for clients in these regions by identifying attractive opportunities in the global markets. The types of instruments available in Europe today are similar to those available in the US and include corporate bonds and asset- and mortgage-backed securities. Active management of a cash portfolio provides better diversification with the use of a broad range of highly liquid instruments, thus reducing the overall credit risk of the assets. Our goal is to create the optimal portfolio tailored to the needs and investment objectives of our clients such as liquidity, income requirements, and capital preservation of the portfolio.
Robin Cresswell is managing director of Payden & Rygel Global in London