Customers of banks have for years accepted low returns and indifferent service from those who acted as custodians of their cash. There was an assumption that the price for this safe custody was the surrender of all rights to meaningful interest earnings. In the retail sector that is being challenged by the new breed of branchless e-banks, buying market share through subsidised interest rates.
In the institutional arena, too, this assumption is being challenged by competitive pressures and the growing trend to outsource cash management to fund managers. Once the provision of safe custody is dealt with as a separate issue, it becomes possible to look at cash as an investable asset.
A recent survey showed custodial banks paying rates well below those available from a cash fund. As a manager of a prominent pension scheme said: “Trustees have got to realise their members can really be losing out by leaving the investment of their cash to default, rather than getting the best market rates.” To put it into context for a £100m scheme, even a difference of 0.1% in returns would generate £100,000 a year.
Developments in technology mean that maintaining access to cash does not require it to be placed in a given physical location. Global money transmission has opened up the possibilities of money management so that this once residual item in pension fund assets can be given the attention it deserves.
The money markets are an area once dominated by the discount houses and merchant banks; specialists at making money through the trading of wholesale financial instruments. The shape of the money market curve reflects a whole variety of aspects of monetary conditions and as a result presents a whole range of opportunities for the experienced practitioner.
Conditions of supply and demand vary on a daily basis and the volatility of short-term rates can be quite extreme. The provision of daily liquidity to the markets to ensure that financial transactions settle smoothly is overseen by the Bank of England, which operates on a daily basis to relieve shortages via the ‘repo’ market.
By setting the level of official base rates, the Monetary Policy Committee of the Bank of England establishes the anchor at the front end of the yield curve. The slope of this curve is then established by the activities of the money market and bond market players. By actively managing assets along this yield curve, investors can generate significant excess returns over those available from a passive investment in bank deposits.
This involves the use of negotiable instruments allowing investors to take gains and benefit from the changing opportunities presented by the markets. As a result duration can be actively managed and treated distinctly from the liquidity constraints that might otherwise apply.
Employing a fund manager to maximise these investment opportunities ensures that one can avoid the conflicts of interest that naturally arise when dealing with a bank acting as principal.
The first issue to address when looking to outsource liquidity to an active investment manager is to determine an appropriate benchmark for the fund. This will establish the safe haven position, where in uncertain investment times the manager will position the assets.
Clearly the shorter the benchmark, the nearer the fund will be to targeting the risk-free rate of return as its default position. Cash funds generally use benchmarks starting at one-week Libid, extending to one, three or six-month Libid. At the extreme, hybrid benchmarks are used, utilising a mixture of cash and short (one to five years) bond indices. These are particularly used by certain insurance funds where asset/liability matching is more of an issue.
The investment parameters are then established to determine the scope the fund has in straying from the benchmark. These can be very flexible. Some local authority cash funds, where the mandate is expected to last for some years, allow a maximum weighted average maturity (WAM) for the funds to be as long as three years while permitting individual maturities as long as 10 years. These funds, however, remain governed by a one-week Libid benchmark. On a simple basis, that allows funds to have a duration profile of 156 times their benchmark!
The outperformance of the benchmark given these parameters can be quite spectacular. Managers operating under these guidelines have in some cases produced average returns in excess of their benchmarks of over 1% throughout this last decade. Last year alone, this excess return could have exceeded 2%!
Even funds governed by maximum WAM of 60 days were able to generate excess returns of nearly 50 basis points last year. In more usual market conditions funds run along these more conservative lines would be expected to generate returns roughly in line with one-week Libid.
Access to this product can take the form of a segregated account held at an independent custodian. A fund manager is then appointed to manage these assets. The advantage of this approach is that it allows the institution to tailor the mandate to reflect its own particular needs. The drawback is the need to enter into management agreements, take legal advice, appoint custodians etc.
Access is also provided by a range of pooled institutional products available, many of which carry AAA ratings. The advantage of this approach is that the work has already been done and the fund will have a custodian and administrator already appointed, the legal bills have already been paid and generally accounts can be appointed on the same day! Because of the inherent nature of a pooled vehicle, investors are also able to benefit from each other’s liquidity profiles, so that these funds usually offer same day access for investors.
Advances in electronic banking technology also mean funds can be linked to custodial bank accounts, allowing sweeping of cash balances both into the funds and from them. In this way the fund operates as the much better equivalent of a call account.
Risk management of these funds is obviously crucial bearing in mind the disparity between the benchmark and the investment parameters in some mandates.
In the case of the AAA-rated money funds, the rating agencies impose very strict guidelines covering investment parameters, credit exposures, risk management, back office procedures, and investment process. They then monitor the portfolios weekly to ensure adherence. Since these funds are intended to preserve capital value, the investment restrictions are very tight so as to reduce the risk of any market or credit-related loss upon a forced liquidation.
The fund is revalued on an amortised yield basis and also on a mark-to-market basis. The net asset value of the fund calculated under these two methodologies may not deviate by more than 0.5% without threatening the AAA rating. Any credit downgrade of any of the assets in the fund also triggers action from the fund manager. The credit exposure of the fund also has to be approved by the rating agency and is subject to very strict criteria. Generally no more than 5% or 10% can be exposed to any one name, all of which must be rated at least A1, with 50% rated A1+.
In a segregated fund with looser investment parameters, the risk management is focused more on market risk exposure. The key to successfully outperforming the benchmark lies in the investment process. This should provide a coherent framework from which model portfolios and investment bets are taken. In simple terms, if the fixed income strategy is to be long of duration against benchmark indices, then it may well be appropriate for cash benchmarked funds that are able to take longer duration bets, to also hold fixed income products. Conversely, if the outlook for bond markets are poor and the model bond portfolios are short of their benchmarks, then it would be very odd to find cash funds holding any bonds.
For the cash fund, the trick is to hold bonds only when their value is rising (to make capital gains) or when they are holding their value but generating a yield pick up over short term deposit rates. Clearly ‘excess’ returns can also be achieved through pure credit arbitrage.
Whatever investment parameters are used to contain market volatility, there is no longer any excuse for pension funds to continue to ignore their cash assets.
Christopher Oulton is head of UK institutional business development at Investec Guinness Flight