We live in risk-averse times. Consumer confidence in the major economies is either weak or falling, risk premiums have risen following the terrorist attacks of 11 September and the IMF has warned of a global recession.
In such a difficult economic environment the management of low-risk asset classes, such as cash, takes on particular importance as a source of both risk management and added return for investment portfolios. However, fund managers and corporate treasurers often fail to make the most of their cash investments, traditionally leaving liquid assets to languish in low yielding bank deposit accounts.
According to a survey of corporate treasurers* that we carried out last year, as many as 83% of respondents said bank deposits were their preferred investment instrument for cash holdings. A similar trend is true for pension funds. But, thanks to the growth of higher yielding cash investment vehicles, such as money market funds, European investors no longer need to suffer the mediocre returns offered by bank accounts. It is time, therefore, that investors stopped treating cash as a sleeping asset class.
Money market funds, popular in the US for the past 30 years, are a relatively recent newcomer in Europe and are only now growing in popularity. Thanks to the benefits of pooling cash reserves, money market funds are able to offer investors higher yields and higher levels of security than traditional bank deposit accounts, but with no compromise on accessibility or client service. In fact, money market funds are actually able to offer greatly enhanced liquidity solutions and innovative cash delivery developments, making them an even more useful way to manage cash investments. Also, corporate treasurers can cut costs by outsourcing cash management costs.
Money market funds operate by pooling investors’ assets across a number of high-quality short-term money market instruments. Fund providers carry out their own detailed credit analysis and surveillance to ensure that risks are minimised, while the pooled nature of the funds means that investors are not exposed to the balance sheet risk of individual banks and custodians. Because the counterparties themselves are the underlying assets of the funds, investors can achieve a spread of counterparty risk through a single investment.
This structure and level of diversification means that money market funds can achieve the highest credit ratings from Moody’s and Standard & Poor’s, in contrast to the banking sector, which has recently slipped down the credit scale following several high-profile banking collapses in the 1990s. Therefore, by pooling cash in a money market fund, investors can achieve higher levels of diversification and security than are available through bank deposit accounts.
Security is highly important, but bank deposit investors pay for lower credit risk with lower interest rates. Our corporate treasurer survey revealed that investors look for credit ratings of at least A2 or Aa2 (Moody’s Investors Service) and most expect to receive a gross interest rate on their cash deposits of Libid (London intra-bank bid rate) minus 0.05% for this credit risk. In our experience, pension funds often receive a lot less than this.
In contrast, thanks to the pooled diversification of credit risk in money market funds and the ability of fund providers to carry out rigorous research to assess risk themselves, many money market funds are able to achieve the maximum Aaa Moody’s rating. But, whereas bank deposits offer lower interest rates as credit ratings increase, liquidity funds can offer higher levels of interest than those available from the banks by extending the maturities of some of the investments that they hold. Also, active money market managers can further boost yields by seeking out the best risk adjusted returns.
Most fund providers keep a certain level of holdings in short-term or overnight instruments, to maintain high levels of liquidity. But, once these liquidity requirements have been met, money market funds are free to invest in securities with longer maturities to increase yield for their investors. Banks often also use cash deposits to invest in longer maturity instruments, but unlike money market funds, the profit from these investments goes straight to the bank itself and not to deposit holders. As a result, money market fund investors should expect interest rates of Libid or above, which is significantly higher than those offered by the average bank account but with the added advantage of a higher level of security as well. What’s more, money market fund assets are usually fully ring-fenced and held ‘off-balance-sheet’ from the fund provider.
Money market funds offer high levels of security and high yields compared to bank deposit accounts, but they do not compromise on ease of access and flexibility. Most offer same-day settlement and late dealing deadlines so that investors can gain access to their cash when they need it. Using money market funds, pension funds can react, for example, to unexpected cash inflows late in the day after the money market providers have squared their positions. But this is not all. Most providers do not charge a fee for cash coming in or out of their funds so that maximum liquidity is maintained. Also, money market fund shares are often priced at ‘constant net asset value’, which means that the funds operate in the same way as a bank deposit. Income is compounded daily and paid monthly, and can be taken as cash dividends or reinvested in new shares. Alternatively some liquidity funds offer ‘roll up’ shares, where income is accrued daily but not distributed. Instead, it is rolled up in the fund, providing some investors with possible tax deferral opportunities.
Many money market funds also offer other pioneering solutions to improve the efficient management of cash. These include same-day liquidity without penalty, late cut-off times, two-way daily cash sweeps and the automatic sweeping of uninvested cash from portfolios to ensure that all cash is optimally invested at the end of each day. We also have developed a global internet cash portal, which allows investors to access their accounts and transact online.
Either way, these innovative and useful features increase the flexibility of money market funds and add to their advantages over cash deposits. It is therefore imperative that a liquidity fund provider is chosen with a dedicated client service team. However, when it comes to choosing a liquidity fund provider size is also important. Providers with the largest resources, most funds under management and the most experience are able to offer the greatest diversity of products and an increased level of liquidity. Meanwhile, larger funds allow the manager to take advantage of economies of scale when carrying out transactions. The benefits from this can be passed onto investors. European institutional investors are now beginning to realise the many compelling advantages money market funds hold over bank accounts when it comes to the optimal management of cash assets. Through education, including the work of the Institutional Money Market Funds Association (IMMFA), investor awareness of money market funds is growing, a development that has been further helped by the growth in the overall European money market fund marketplace.
In our corporate treasurer survey last year we found that, although bank deposits remain the most popular choice by a considerable margin, money market funds are the second most popular, and they led the field in terms of the investment instruments whose usage treasurers intended to increase in the future. Further evidence of the trend towards money market funds is expected from this year’s survey. We have seen a 97.8% growth in our funds under management into our money market funds so far this year to 19 October.
Peter Knight is head of institutional liquidity funds at JP Morgan Fleming AM in London.
*The Association of Corporate Treasurers UK Cash Management Survey 2000, in association with JP Morgan