Time to look at all the options for cash
Cash has rarely been considered a strategic asset class in the pension fund investment environment. Historically, its main role has been as a tactical asset class. Ensuring the efficiency of the investment arrangements has meant ensuring that the balance between equities and bonds is appropriate to the pension fund’s liabilities and circumstances, and that corresponding equity and bond mandates are in place. The efficient management of cash has often been an afterthought – a matter of compliance to deal with cash arising from the equity and bond managers’ settlement transactions and tactical investment decisions, and the need to hold sufficient cash to meet forthcoming payments. Cash has consequently been awarded an inferior status as an asset class and often left to lie fallow in bank deposit accounts. It seems unlikely that that such laissez faire management of cash can persist as fiduciary requirements continue to tighten and better options become widely available to pension fund investors.
The efficiency of cash management is assessed under three criteria: security of the cash holding, liquidity to ensure that the pension fund’s payment requirements can be met as they arise, and the maximisation of yield, subject to adequate security and liquidity.
The deposit accounts that have historically serviced pension funds’ cash management requirements may no longer satisfy these criteria. By holding a deposit account, the pension fund is one of the bank’s unsecured debtors, and as such is exposed to the bank’s balance sheet. Post-Barings, with banks’ credit ratings declining across Europe so that there is now only one true AAA-rated European bank, a single bank account is no longer perceived as a perfectly secure place for pension fund cash. To make matters worse, those banks with higher credit ratings tend to offer lower interest rates so that Europe’s highest quality banks can at best satisfy only two of the criteria, namely security and liquidity, and even then the security offered is no longer seen as optimal.
Where cash is mostly handled by the equity and bond investment managers, it is generally placed in a number of deposit accounts and some may also be left some in a custodian account. This type of arrangement remains surprisingly common, especially as better technology and sophistication in the management of cash becomes available. It is unlikely that, for the relatively small amounts of cash held by an individual pension fund, meaningful diversification can be achieved in this way to enhance the security of the cash holding. This problem is exacerbated in investment arrangements that include more than one investment manager. Indeed, there may be no third-party checks to ensure that investment managers are not using the same counterparties and thus breaching the overall pension fund’s exposure limits. Further, fragmenting the cash holding in this way may result in a lower overall yield on the cash holding, as most banks will award lower deposit account interest rates below a threshold level of cash deposited.
These problems can be addressed to some extent if a master custodian is mandated to manage the pension fund’s cash, particularly where electronic sweep programmes, or ‘zero balancing’ arrangements are used. These are programmes run by custodians, ideally a master custodian, which sweep across a fund’s holdings and remove actual and projected cash each day for consolidation of cash holdings from bank accounts into a single account. The sweep can allow for cash required by the investment managers to settle trades, thereby ensuring a zero cash balance at the investment managers at the end of each day. However, using a master custodian account concentrates the counterparty risk to a single custodian, and the pension fund may be exposed to the master custodian’s balance sheet.
Liquidity funds offer greater efficiency and sophistication in addressing the challenges of cash management. This type of fund, which grew out of the US savings and loans crisis of the mid-1970s, is becoming more widely available in Europe and offers enhanced security and yield to investors, without compromising liquidity. In other words, relative to the bank deposit accounts that pension funds have been accustomed to using, liquidity funds offer lower risk and higher return – a rare opportunity indeed!
The structure of liquidity funds is designed to mirror the operation of the more familiar bank accounts. Shares in US-style liquidity funds are priced at a constant net asset value of one currency unit. Cash is invested on a day-by-day basis and income declared daily for each day’s balance and separately accrued to the end of the month. The only fee charged is that payable annually within the fund, which is deducted daily from the accrued income. No fee is applied to the capital or to cash coming in and out of the fund. This structure ensures that the liquidity required by investors is preserved.
Liquidity funds enhance security of the assets relative to bank deposit accounts by pooling investors’ assets to diversify across a number of high quality short-term investments. Further, many providers will undertake their own dedicated credit research and surveillance, and not rely on the major credit rating agencies. Holdings typically include repurchase agreements, commercial paper, certificates of deposit, medium-term notes, promissory notes, bank bills and perhaps some deposit accounts. As liquidity funds are constituted as pooled investment vehicles, investors are no longer exposed to the banks’ or custodians’ balance sheets. The counterparties are the underlying assets which means that the pension fund achieves a spread of counterparty risk through a single cash investment. This structure and level of diversification means that liquidity funds can achieve the credit rating of AAA that is no longer attained by Europe’s banks.
By pooling cash with that of other investors in a liquidity fund, the problem of achieving adequate diversification without giving up access to higher deposit account interest rates is resolved. Yield on liquidity funds is also enhanced by extending the maturity of the assets held. Most providers will retain at least 40–50% in short-term or overnight instruments to ensure that investors’ liquidity requirements are met. However, once liquidity requirements are satisfied, yield can be enhanced by investing in assets with longer maturities (up to 13 months in a US-style liquidity fund). It is worth noting that although the assets backing traditional bank and custodian accounts are likely to be invested similarly, the investor does not have direct exposure to these assets and therefore does not benefit from them. Any enhanced yield relative to the deposit account interest rate achieved by holding longer-term assets becomes profit for the bank or custodian.
In the US, liquidity funds are tightly regulated in terms of the quality of the assets held, the maximum term of the investments, the average term of the investments and the requirement to provide daily liquidity. This type of legislation has not yet been put in place in Europe, and European money market funds are consequently much more vaguely defined. For example, the Association of Unit Trusts and Investment Funds identifies all trusts with at least 80% of their assets in money market instruments as ‘money market trusts’. The result has been that there has been very little conformity of money market funds across Europe, and the principle of simulating the behaviour of a bank account has not applied. In particular, share pricing is not typically at constant net asset value, dealing may not be daily so that liquidity is not guaranteed, and fees may be levied on capital as well as income. These types of funds may not offer the clear advantages of US-style liquidity funds. However, a small but growing number of providers in the European market have embraced the US approach to liquidity funds. A credit rating of AAA from one or more of the major credit rating agencies indicates that the fund is managed to a set of criteria laid down by the rating agency - these criteria are modelled on the US legislation for liquidity funds.
It is difficult to see how cash can continue to be conveniently hidden away in bank accounts as this type of product becomes more widely available to pension funds across Europe. Cash can now be managed and measured with transparency against a benchmark, and can be made to be more secure without compromising liquidity. Efficiency can be further enhanced through the use of electronic sweep programmes provided by a master custodian. As US-style liquidity funds become more widely available in Europe, they must surely become the standard against which institutional investors assess the efficiency of their own cash management arrangements.
Sorcha Kelly is with the asset consulting practice at Towers Perrin in London