Residual or strategic?

Large amounts of pension fund cash are held in current accounts: it is estimated that 40% of all cash is held this way. But money market fund providers say there is a better way. Putting the cash in funds not only generates better returns, but also improves credit security.
Money market funds are pooled vehicles which hold a mix of short-term debt instruments, and are designed to preserve capital and protect income while limiting exposure to interest rate shifts.
“It’s probably just a mixture of convenience and inertia,” says Tom Meade, investment director, cash management, at Royal London, explaining the huge cash sums held in current accounts. Royal London runs segregated cash accounts, with £2.5bn (e3.7bn) under management and around 150 clients. The clients range from £1m to £400m in total assets.
One problem is that cash management in general is a low profile operation. “Nobody notices if you do a good job,” he says. There is not perceived to be a pressing need to gather an extra 10 or 20 basis points for cash balances.
“It depends on the size of the pension fund, and the amount of cash they have. If a normal fund has 3-5% in cash, they could be earning an additional 10-50 basis points on it,” says Meade.
Many funds end up leaving their cash with the custodian. Some custodians offer to manage the cash for the pension client, says Meade, but there is usually quite a high fee for this service. “Or they can do it themselves, or use a money market fund.”
The trouble with using a third party money manager is liquidity. Pension funds need to be aware of what their liquidity needs are, what the charges are, and the market rates for cash. A third party manager might typically charge 10 basis points, while custodians could charge double that, he says.
Within money market funds, there is a choice between AAA-rated funds which cannot have durations longer than 90 days, and enhanced or ‘plus’ funds which can go up to 120 days. Beyond that, are money market funds which operate like mini-hedge funds, says Meade, and have some volatility.
Though traditionally pension funds have held their cash as bank deposits, Henry Buckmaster, head of direct channel, UK institutional, at Investec, they are looking beyond these now. “There is a move in the sector towards being slightly more proactive,” he says, with funds using pooled AAA-rated funds or a mixture of that and bank deposits.
Custodians can be the gateway. “Custodians now themselves are either pooled money market operators or they use them,” says Buckmaster. “They are under a duty to look after cash, whether it’s residual or strategic.”
There has been a huge rise in the use of money market funds over the last five years. “In many respects, the pooled funds are becoming the default place for liquidity,” he says.
According to data from the Institutional Money Market Funds Association, funds under management within institutional money market fund funds has grown to $232bn (e184bn) at the end of 2004 from $102bn at the end of September 2002.
As opposed to deposits, money market funds do not give fixed returns. “They buy and sell up and down yield curve, seeing where there is best value,” says Buckmaster. Returns will mirror base rates most of the time, he says. But apart from the returns, there is the advantage that investment risk is spread across typically around 20 different but AAA-rated borrowers.
This diversity, along with the instant access they offer, and the transparency, gives money market funds an advantage over deposits with a single institution.
Shana Laven, product manager for the SSGA Cash Management Fund says pension funds could be putting themselves at a disadvantage if they simply use their current account to hold their residual cash.
“They can internally self-manage the money, or outsource it to a cash management fund,” she says. With outsourcing, the fund can take advantage of the professional expertise of the provider, she says, pointing out that State Street Global Advisors has 25 years experience in managing cash management accounts.
When choosing a money market fund, it is important to find out when the cut off point is during the day, for making withdrawals. “The AAA offshore funds all have daily liquidity,” she says. “Each fund has a deadline each day, and as long as you make your subscription within that day, you’re going to receive your money.”
But a fund with a cut off at noon gives you less flexibility than a fund with a later cut off, she says. Both of SSGA’s sterling cash management funds have a 1pm cut off, she says, but there is also a dollar fund which has a cut off of 8pm London time.
Credit is not an issue with the funds, she says. They are UCITS registered, and rated by ratings agencies. “We have 12 dedicated short-term analysts specifically looking at cash,” she says. “We ensure that all of our counterparties are of high quality.”
Where cash might otherwise be held in an equities portfolio, often the best solution for investing this is to equitise it, rather than making the best possible cash invesment.
Nathan Dudley, senior portfolio manager, implementation services for Russell Investment Group, says that where the benchmark is a fully invested one, it is important for all the assets to remain in that asset class.
“If you hold cash but your benchmark doesn’t include it, then two things will happen,” he says. “Your tracking error will be higher, and in the long-term there will be performance drag.”
Equity managers are typically given the freedom to hold up to 5% in cash, and in practice, cash levels can often be around 3%. “One type of cash holding we don’t recommend doing anything with is within fixed income portfolios,” he says. “This is because managers usually use it as part of their duration bets.”
But simply equitising cash would be wrong some of the time. If a fund is already holding a high equities allocation in a bearish situation, then equitising spare cash will only exacerbate the problem. The answer is ‘smart securitisiation’ rather than blind equitisiation, he says.
It is a matter of drilling down to see what is cash and what is equities, then purchasing futures contract that have a notional value equivalent to that cash, he says.

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