Squeezing a return out of cash can expose funds to unexpected risk. But Charlotte Moore suggests that using it for strategic optionality removes the need to take risk in the search for yield
Cash today is not what it was before the financial crisis. The collapse of Lehman Brothers and subsequent liquidity crisis made investors realise that counterparty and collateral risk, even for supposedly safe money-market accounts, are very real.
To protect economic growth, central banks in the west implemented quantitative easing and kept interest rates low. This has resulted in pitiable cash yields. That problem has been further compounded in Europe as rising inflation has pushed real rates firmly into negative territory.
Even without all of these problems, cash has never been an asset class of choice for pension funds - in good times, it generates neither sufficient yield or capital growth. But for many pension funds a residual 5-10% of the portfolio nevertheless has to be kept as cash, if only to meet unexpected or unscheduled payments. Investors now consider the risks attached to cash, whereas in the past it was treated as a passive asset class, often simply put on deposit or into money-market funds.
Mark Stockley, head of international cash sales at BlackRock, says: “In the past, the cash would have simply remained with the custodian. But a growing awareness of the risk associated with cash investment, as well as attempts to maximise returns, means that pension funds now pay much more attention to actively managing cash.”
Marcus Littler, director of liquidity sales at BNY Mellon Cash Investment Strategies, agrees. “Pension consultants are reviewing cash in much greater detail than they did in the past,” he notes.
Many pension funds, however, still have unrealistic expectations about the returns that can be generated from cash. BNY Mellon’s Laurie Carroll notes that both pension fund trustees and their consultants will ask why returns are only LIBID rather than LIBOR. “But LIBID is the return that the cash markets are currently generating,” she says.
It is, of course, possible to generate higher returns than LIBID but that does mean taking on other risks.
Higher returns can be earned if only 30% is kept as pure cash and the rest of the portfolio is invested in longer duration products, with maturities of up to a year. Investing in products with a duration of 60 days or more will generate higher yield than pure cash because it is then possible to invest in short-dated fixed income products.
Paul Cavalier, partner at Mercer, says: “There is no point in investing in real cash products at the moment, especially given that yield curves around the globe are very steep. It makes more sense to invest at longer duration and just roll down the curve.”
While this kind of strategy does create higher yield, it also increases counterparty, collateral and liquidity risk. “Pension funds need to apply the same due diligence to selecting a cash management strategy as a corporate treasurer applies to the task,” says Carroll.
Those risks can be minimised by sticking to approved providers, focusing on the right geography, carrying out careful credit analysis and ensuring the assets are purchased at the right price.
Despite the current low yields that cash generates - and the risks associated with squeezing out a little more yield - the uncertainty in the financial markets could result in pension schemes increasing the amount of cash in their portfolio.
Lack of clarity in global risk markets makes it tempting to keep accumulated cash on hold until the outlook becomes more stable and predictable. Christopher Redmond, a senior investment consultant at Towers Watson, would not approve.
“Given the structural advantage of possessing a long investment horizon, a pension fund should remain exposed to the financial markets even when the outlook is uncertain,” he argues. “You might, at the margin, tweak exposures and reduce the allocation to risk-seeking assets if the economic outlook is uncertain. That extra cash could be used to purchase assets that would perform well in a bad environment and act as a portfolio hedge.”
Some investors, however, do not agree with this philosophy and deliberately allow cash to accumulate in their portfolios. But rather than accumulating cash because market uncertainty makes them too terrified to invest, they are pursuing a very deliberate strategy to accumulate cash ahead of a re-pricing event.
Of course, if the aim is to use your cash holdings to implement a more effective investment strategy, that requires an entirely different attitude to that asset class.
Cavalier says: “If you want to treat cash as this kind of transitory asset class, then there’s no point in looking for value in this asset class; you are using it to protect against capital losses elsewhere in the portfolio and to increase the liquidity of the fund.”
While larger pension funds should have enough in-house expertise to use cash as a transitory asset class, this does not make as much sense for smaller pension funds. For these types of fund, it would make more sense to select fund managers who are capable of implementing this strategy within their individual portfolios - and then give them the mandate to do so.
Richard Ryan, manager of M&G’s Alpha Opportunities Fund, believes that more funds should keep cash instead of using it to buy derivative strategies to hedge against potential losses. Derivative strategies cost money to put in place, can require margin calls, and introduce hard-to-manage market-timing challenges. Ryan thinks that too many institutional investors undervalue the flexibility of cash.
“Rather than putting an ever more complex derivative in place, having a chunk of the portfolio in cash is the cheapest and easiest way to take advantage of a sudden re-valuing of an asset class,” Ryan says.
He continues: “In 2009, plenty of managers were fully allocated and unable to make the most of the unbelievable value that arose. This summer we had a 20% cash allocation. At the time we felt that the market was being overly optimistic about the outcome of the European sovereign debt so we deliberately decided to hold back from investing.”
Of course, this strategy will only be successful if the investment manager has the discipline to either sell assets at the top of the market or not feel compelled to constantly invest new inflows.
That requires a strong investment philosophy and a cohesive team. “We do not buy an asset unless it will generate the required return. You need to be patient and opportunistic,” Ryan says.
In a Japan-style deflationary scenario, there is no doubt that cash has its attractions. In the more usual inflationary scenario, rolling down the curve at the short-end can work well - except, like now, when monetary authorities are desperately trying to maintain curve steepness and reaching for extra yield is either a thankless or a risky task.
But if an investor expects the current market volatility and uncertainty to persist - and very few do not - the strategic optionality of cash may well be the quality that is truly coming back into its own.