Let’s be honest, in a world of competing priorities cash management never seems to quite make it onto the hot ‘must do’ list but seems to hover, ghost like, just outside the activity zone. There is rarely an urgent imperative promoting it up the scale.
This is a pity as the fundamental principals of good cash management are easily understood and a straightforward framework for effective cash management relatively easy to introduce. The starting point is to decide what, in your own context, your cash is for and what is important to you when looking at its management.
Unsurprisingly preservation of capital is the top priority for most cash investors, as cash is generally not seen as an appropriate asset to take undue risks with. This implies that the return on cash holdings is of secondary importance as any excess return could eventually be at the expense of a proportion of the original funds invested. The trick is to maximise the return on cash within a prudent framework, the difficulty is determining what is an appropriate return given the framework you have set up.
The other criteria that are vitally important for most cash investors are liquidity and convenience. You want to have access to your cash without undue penalty and to be able to deal with it and its associated administration in a manner that is convenient.
For the majority of cash investors considerations of safety, liquidity, performance and convenience and the different emphasis placed upon them form a matrix from which the final shape of their cash management structure emerges.
What then are the available cash management options? Basically, you can do it yourself or have someone else do it for you or choose a mixture of the two.
Doing it yourself has the great advantage that nobody else will ever know your requirements better than you and that by dealing directly with the market you keep in touch with what is going on in a way that is not possible when using third parties. The potential disadvantage of doing it yourself is that you could spend time and resources on managing cash out of all proportion to its return or importance to you.
Whatever route is chosen you must decide what level of risk you are prepared to take with your cash. Will you just lend to regulated institutions (banks and building societies) or are you happy to lend to non-regulated institutions such as corporates. Many institutions adopt credit rating driven criteria with either a short or long term minimum rating and then draw up a subset of qualifying names that are regularly reviewed. Maximum exposures can be attributed to each institution to ensure adequate diversification.
The front line in cash management is your bank or custodian. They will provide current or interest bearing accounts or possibly access to their own money market fund or treasury desk. Cash left on a non-interest bearing account has a high opportunity cost so is best avoided unless there is an offsetting arrangement such as free banking or a reduction in costs elsewhere. Even so, such arrangements need to be reviewed on a regular basis to make sure that what made sense for you last year has not become, through inertia, an arrangement that now more clearly favours your bank or custodian. A facility that allows cash to be swept into an overnight or call account can be extremely useful as it can be set up to operate automatically and provides a failsafe against money arriving unexpectedly on the account and lying idle overnight. Again it is important to understand what rates are being paid on these types of accounts as it is unrealistic to expect rates that would compete with the money market.
Cash can also be swept into a money market fund connected to the bank or custodian. While this should produce a higher return than other short term arrangements it is important to remember that it is not the same as a deposit but an equity investment in a company that itself investments in a portfolio of money market assets. Money market funds are not guaranteed and like all investments it is possible to lose money. Although they generally have a AAA credit rating they are only as good as their underlying investments and their minimum credit rating is a short term A1 or P1. While they provide good diversification and liquidity they may be investing in a wide range of assets some of which you wouldn’t necessarily feel comfortable investing in directly.
Having looked at the options available on your doorstep through your bank or custodian (and this should include speaking directly to their treasury desk) the next step is dealing directly with other counterparties in the money market. As a first stop banks sometimes offer call or near instant access deposit accounts paying rates connected to base rate. If the counterparty is acceptable to you from a credit point of view then these accounts can provide a good second line of liquidity without too much effort.
The next step is dealing in the money market with a range of counterparties through time deposits, certificates of deposit and other money market assets. This can be done directly or through an investment house managing a segregated portfolio on your behalf. Whether done directly or indirectly the construction of the portfolio will depend on the amount of cash involved, liquidity considerations and the appetite for risk.
If the portfolio consists solely or primarily of time deposits then the expected cash flows on the portfolio need to be fairly accurate. The use of certificates of deposit and possibly commercial paper adds considerably to the flexibility of the portfolio as these assets can be sold in the market to provide liquidity and therefore they are attractive for a portfolio where the cash flow is uncertain or a portfolio where extra return is sought from positioning on the yield curve.
The majority of institutional cash management has a time frame between call or overnight and investments out to twelve months maturity. As a rough rule of thumb the longer the average maturity of a portfolio the higher will be the return but the greater will be the volatility of that return. To protect against loss of capital through large movements of interest rates money market funds are restricted to a maximum average life of 60 days. This could be restrictive for an individual tailored portfolio so a maximum average life of 60, 90 or 100 days would give greater opportunities to increase return without excessive exposure to unexpected movements in rates.
The average life of a portfolio does not tell the complete story however as the average could be the same on two portfolios but the composition of the portfolios very different. One could achieve an average life of say 90 days through a ‘laddered’ approach ie, a series of uniform monthly maturities made in investments ranging from one month to six months. The other portfolio could also have an average maturity of 90 days but achieved through a ‘barbell’ approach ie, a significant proportion of the funds invested in 12 month maturities balanced by the remainder of the portfolio being kept relatively short. Each portfolio would perform differently in different interest rate environments.
There may only be one or two opportunities a year to take a positive interest rate view on a portfolio so for most of the time the profile of investments will be market neutral with investments being kept below three months maturity. Such a market neutral approach also indicates that an appropriate benchmark should be in the same maturity band, with benchmarks of seven, 30 or 90 days being the norm.
Institutional cash management is an interesting mixture of art and science. A clearly thought out approach based on the requirements of your own institution will provide a robust structure for managing cash but the day to day operation of the structure will always be a combination of dedication to detail and the occasional flash of inspiration!
Tom Meade is head of cash management at Royal London in London