Institutional investors are paying increasing attention to the returns achieved on cash. Although not dependent upon the trend towards specialist management of individual asset classes, this has clearly increased the focus on cash returns. All schemes will necessarily hold frictional cash balances, irrespective of investment view, which as a potentially large part of the portfolio should be handled as efficiently as possible. In the case of smaller funds this can be met sufficiently by the range of pooled products available at present. However, for the larger schemes, segregated cash management can provide a degree of specialisation which will improve returns at the overall scheme level.
Specialist management can provide a fund structure specifically tailored to the individual scheme’s needs. This can be in terms of the appropriate maturity structure, borrower diversification, individual security maturity, and the range of money instruments permitted within the portfolio. In many cases, the flow of funds through the cash account can be substantial although in most situations there remains an underlying core cash holding. Therefore it is often possible to extend the average maturity of the core holdings, but still retain same day liquidity.
By extending average maturity, the assets can take advantage of the typical yield enhancement that the market provides. Historically in the UK one-month interest rates have offered a yield enhancement of 0.125% over and above one-week interest rates. And yet, with dedicated money market dealers, investment in longer dated assets need not compromise the liquidity or credit quality of the fund. By investing across certificates of deposit, commercial paper and possibly short-dated floating rate notes, the portfolio can be structured to retain same day liquidity on the vast majority of the assets. In such situations the benchmark should reflect the proportion of the fund that is regarded as the core cash holding – it is this proportion that the scheme should consider benchmarking against maturities in excess of one week.
The specialist mandate also allows the client to determine the maturity limits on the fund, not only in terms of the average maturity of the fund but also the maturity of any individual asset. Again this should be agreed in advance with the manager, but should reflect the skills of the manager and the scope to which the manager would expect to use yield curve and maturity exposure to add value to the portfolio. Managers with proven skill in adding value through interest rate forecasting as well as stock selection should, wherever possible, be provided with the scope to use these skills. Investing in assets with longer maturity will allow the manager to lock yields ahead of any potential fall in shorter-term rates.
Similarly, many opportunities arise through the appropriate use of the floating rate note market. For accounts without the need for 100% overnight liquidity these provide excellent opportunities for yield enhancement. Typical issuers are the large financial institutions present in the other areas of the money markets offering yields on notes with five years to final maturity of up to 0.25% in excess of cash rates on equivalent names.
This diverse range of instruments, maturities and borrowers demonstrates that the institutional money markets offer a number of valuable yield enhancing opportunities which if used appropriately need not compromise either the average credit quality of the money market holdings or the necessary level of liquidity on the holdings.
However, it is only by tailoring the limits to the individual needs of the scheme that the scheme may gain the most from its cash holdings. These limits should reflect minimum levels of liquidity, diversification and credit quality of borrowers, maximum maturity at the fund level and by individual instrument together with a stated benchmark target rate of return and expected downside risk.
To manage such funds requires good quality systems and communications. By offering a bespoke cash management service, the manager needs to ensure a high level of risk awareness but also the ability to monitor individual exposures closely. Key to this is the quality of information flow between the client and the portfolio manager. By providing timely information on likely cash flows the client can ensure that the manager does not incur unnecessary costs, thereby maximising the yield on the fund. Nonetheless this extra information flow is however a small cost to pay relative to the undoubted benefits that specialist management can provide.
Mike Amey is head of UK bonds at Rothschild Asset Management in London