As the choice of cash funds grows, of particular interest to investors has been the development of ‘enhanced cash’ funds. The varied risk and return profiles and naming conventions used in the enhanced cash universe make it a challenge defining what is an enhanced cash fund. The US money market information resource imoneynet (www.imoneynet.com) has its own market segmentation matrix, which provides a reasonable definition (see table).
Stable NAV liquidity funds have a level of homogeneity that makes them more easily comparable, while the ability of an investor to perform due diligence becomes more important when choosing the invest in enhanced cash products.
Enhanced cash risk profiles, sources of return, liquidity and fees are far more diverse. One fund may take active currency risk, while another invests in non-investment grade debt. One may charge a performance fee and others may offer daily or perhaps weekly access.
Even this analysis ignores many other factors that an institution should consider before investing in a particular enhanced cash or Libor-plus product. Here are some other considerations:
n Provider/fund track record: Length and strength of track record.
n Level of resources dedicated to enhanced cash: Portfolio managers, credit analysts, research analysts.
n Experience of team: How long have the investment professionals been managing in this sector?
n Transparency of process and performance.
n Risk management process and controls.
Typically, a face-to-face meeting with the manager is the best way to drill down into the detail and assess its ability to deliver the expected return in a risk-controlled manner. It is no good just looking at a snapshot of performance at one point in time (this holds true for most other classes too, where managers invariably pick periods that show their product in the best possible light).
Using asset-backed securities in enhanced cash funds has a number of advantages. The interest rate risk or duration is similar to a money market instrument. The volatility of returns from interest rate moves should be fairly low, but a yield premium is available over money market assets. Rating agency data shows that the rating volatility of asset-backed securities is lower than bank or corporate credit ratings across the rating spectrum. This typically means that the credit spreads on asset-backed securities are less volatile than spreads on bank or corporate assets.
While lower volatility of returns is an important factor, the data also suggest that the probability of default of asset-backed securities is lower than that of corporate issuers across the rating spectrum. This is particularly important for those funds that invest in lower-rated assets.
Asset-backed deals typically have tranches across the rating spectrum, from AAA to BBB and beyond. This means the asset class is very flexible, allowing investors to take structural risk and credit risk in one investment.
Derivatives are beginning to be used in the more sophisticated products. Recent changes to the UCITS regulations, which cover EU based investment funds, allowing the use of derivatives, are recognition that they are simply a different way of implementing an investment strategy. As long as the manager has experience of using derivatives and the necessary risk controls in place, they can be useful tools for implementing portfolio strategies efficiently, hedging risk as well as taking active positions.
For example, interest rate swaps and exchange- traded futures may be used to implement a quantitatively based interest rate overlay strategy. Using the derivatives is more cost efficient than using the physical bonds. Total return swaps would be used to gain immediate exposure to the asset-backed market rather than purchasing physical assets. This would help avoid ‘cash drag’, whereby the cash is invested in money market instruments that offer a lower premium than asset-backed securities as the portfolio of physicals is built up over time, thus creating a drag on the fund’s performance.
Credit default swaps might be used to hedge assets, if our opinion on the credit quality of the asset changed. As liquidity improves in the asset-backed credit default swap market, it is expected that credit default swaps will be cheaper to use than selling the asset outright. However, derivatives are not without their specific risks. Controls and systems must be in place to manage counter-party and correlation risk inherent in the use of these instruments.A fund structure that has the ability to combine a range of different currency share classes that invest in one core fund provides investors with access to a diversified pool of global asset-backed securities. Meanwhile foreign exchange exposure is hedged, hence the fund delivers a return targeting short-term interest rates in the respective currency of the share class.
Central banks and supranationals, together with certain corporates and financial institutions, have tools that are capable of analysing the varying available products. This is just as well when a product’s risk profile is often a factor of active currency exposure, use of derivatives or use of sub-investment grade debt. But that level of sophistication isn’t the case across all investors, so a little client education on product specifics would probably help.
Jonathan Curry is principal, head of European cash management, at Barclays Global Investors