As investors take a more active approach to their short-term portfolios, they must balance the potential for enhanced returns against risk and liquidity considerations.
Cash, a previously underutilized and overlooked component of most investment portfolios, is a subject of intense focus for many institutional investors. The reason for the increased scrutiny is investors have become more diligent in their pursuit of enhanced yields. As recent market events have underscored, however, the quest for improved performance also must consider evolving market risk and liquidity parameters.
Institutional investors such as corporations, governments, pension funds, endowments/foundations, not-for-profit organizations, insurance companies and hedge funds have diverse investment horizons, liquidity needs, risk/return profiles and volatility tolerances. As a result, an array of investment solutions have been developed to accommodate these considerations as well as to provide an opportunity for increased returns.
“We have seen a proliferation of investment products that reflect growing market demand to provide a broader range of investment alternatives.”
— Steven Everett
Director of Balance Sheet Assets, Northern Trust
“During the past decade, we have seen a proliferation of investment products that reflect growing market demand to provide a broader range of investment alternatives within the cash to short-duration portion of the yield curve,” says Steven Everett, director of Balance Sheet Assets at Northern Trust. “Investment solutions vary from high-quality money market fund strategies with a constant net asset value to low-duration investment strategies with mark to market risk. Such strategies may employ leverage, greater credit risk and other portfolio management techniques to achieve their performance objective, which in many cases is to materially best traditional cash investment strategies.”
Still, subprime woes, the subsequent credit crisis and potential for recession in the U.S. economy during the latter part of 2007 caused what Everett calls a “retrenchment,” with investors and asset managers reducing risk alike. “All of this is reflected in what we have observed in the front end of the Treasury yield curve,” he says. “There has been an implosion in yields, in large part due to the flight to quality. An increasing share of liquidity is sitting on the sidelines with much less sensitivity to returns than in past years. In the short run, it’s more about safety, and, clearly, Treasuries are a safe harbor.”
Jeff Glenzer, executive director of the Corporate Treasurers Council of the Association for Financial Professionals (AFP), a Bethesda, Md.-based organization for corporate treasury and financial management professionals, agrees. “Most conversations with treasurers have been about taking defensive positions,” he says. “They are also worried about securities that were supposedly AAA-rated but are now illiquid.”
Linda Ruiz-Zaiko, president and founder of Bridgebay Financial Inc., an investment consulting services firm in San Ramon, Calif., notes improved performance and risk management are not mutually exclusive objectives.
“Short-duration fixed-income assets and cash equivalents are no longer a temporary sweep but have become more actively managed, generating superior excess returns given a specific risk profile,” she says. “Many of the metrics and risk-control techniques that have historically been applied to other asset classes also can be applied to enhanced cash investment solutions. Factors such as risk can be quantified, analyzed and controlled to meet specific investment tolerances.”
Ruiz-Zaiko says that opportunities that arise from market inefficiencies can be incorporated into actively managed portfolios. “Disciplined, risk-controlled investment processes produce consistent and superior investment results,” she says.
One reason short-term investment strategies are receiving more attention is that investors’ cash positions have become a more strategic component of the overall portfolio. For example, cash and short-term assets at many corporations have risen steadily during most of the past decade. At the end of June 2007, the S&P industrials had amassed $603 billion in cash and equivalents, representing about 6% of their total market value, according to a Standard & Poor’s report.
The richness of the cash position stems from two trends: four and half years of double-digit earnings (ended in 2007) and the lack of merger-and-acquisition activity, which for the past couple of years has been dominated by the private sector using cheap capital.
Traditionally, treasurers and chief financial officers have invested cash in short-term instruments, such as commercial paper or money market funds, until the assets were needed for an acquisition, stock buyback or some other corporate purpose. Institutional investors took a similarly cautious approach with their cash positions as they sought investment opportunities in stocks, bonds or other long-term asset class.
“Cash is an underappreciated asset except when it is not there,” Glenzer notes. The “AFP 2007 Liquidity Survey,” based on responses from 449 corporate practitioners and published in the third quarter, found U.S. businesses are maintaining high levels of cash. In addition, more than a third of companies (36%) are building their cash positions. Other survey highlights include:
The AFP concluded its survey just before the disruptions of the credit crisis, but even then there were concerns among corporate treasury executives about the health of the economy. “Companies just weren’t finding investment opportunities compelling enough to mobilize cash for any kind of permanent investment, or alternatively, to give back to shareholders,” Glenzer says. “Clearly, since we did the survey, the dynamics of the market have certainly not created any additional incentives to draw down cash.”
Corporations are not alone in looking to maximize the returns on their cash positions. Foundations, endowments, hedge funds, investment managers and even states and municipalities are all looking for enhanced performance from their cash reserves.
Hedge funds, for example, usually maintain significant cash positions in their portfolios because they have to keep reserves on margin to trade derivatives. In the past, this money would be parked in Treasuries or low-paying interest-bearing accounts, not really receiving much attention because overall the funds’ focus were on generating double-digit returns from their particular strategy. Now, with hedge funds returns close to equity market returns, every potential additional basis point of return has taken on greater significance.
“Liquidity and risk are the preeminent considerations for cash portfolios in today's market.”
— Brad Adams
cCash and Short-duration Investment Product Manager, Northern Trust
Investment managers face a similar situation. Traditionally, cash was swept into a custodian account and invested in Treasuries, while the manager focused on long-term opportunities. But, with investment management being an extremely competitive field, individual managers have found they needed to actively manage those cash positions as well.
“Historically, investment managers might not have actively managed pools of cash, but it has generated greater attention again because there is so much pressure in the global market on returns. Every asset class is getting scrutinized as to how to do it better. In some circumstances we have seen investment managers more formally organize residual cash in equity or bond portfolios across the firm and outsource that function to a cash/enhanced cash investment specialist,” Everett says.
Cash can be divided into two basic tiers — daily working capital and reserve or strategic cash. Working capital usually is invested in short-term, overnight investments such as interest-bearing accounts and money market funds. Strategic cash, which doesn’t need to be turned so quickly, can be invested over a longer time horizon, most often in enhanced cash or short-duration products with greater return objectives.
“For investors such as corporations that prioritize principal preservation, immediate liquidity and returns, money market funds are the typical solution,” Ruiz-Zaiko says. “Typically, the assets that are deployed to enhanced cash strategies are the surplus reserves of the institutional investor that have a longer investment horizon.”
The objective of enhanced cash products is to outperform money funds on a total return basis with modest interest rate, credit and liquidity risk.
Whereas typical cash funds operate with a duration of up to three months, enhanced cash products use investments that might go out as long as a year.
“Enhanced cash strategies actually provide a very appropriate opportunity for pension cash, insurance reserves and foundation cash, and can be used to duration match short-term pension liabilities,” Everett says. “Enhanced cash also can be applied in portable alpha strategies as a lower-risk portable alpha strategy that backs an equity exposure.”
Ruiz-Zaiko notes enhanced cash strategies can vary, investing in a range of asset classes such as short-duration Treasury and high-grade corporate bonds, floating rate notes, mortgage-backed securities, commercial mortgage-backed securities and asset-backed securities. “Some strategies use derivatives to hedge out volatility, interest and duration risks,” she adds.
The objective of enhanced cash products is to outperform money funds on a total return basis with modest interest rate, credit and liquidity risk. Whereas typical cash funds operate with a duration of up to three months, enhanced cash products use investments that might go out as long as a year.
Cash also is playing an increasing role as prime collateral for return-generating strategies such as securities lending. “Most pensions, endowments and foundations that are engaged in securities lending have sought different ways to manage the cash collateral in the program,” Ruiz-Zaiko says.
An increase in the proportion of less-liquid, structured assets in collateral management is a direct result of the aggressive pursuit of higher returns, she says. Financing and valuing these asset classes are much more challenging than conventional securities. Still, the growing demand for general collateral, and the wider spreads available in financing more exotic forms of collateral, is causing the range of eligible collateral to expand into less-liquid securities.
“Some tri-party securities lending programs also accept equities in addition to fixed-income securities, integrating the management of both equity and fixed income collateral,” Everett says. “A sophisticated collateral manager is required for less-traditional collateral such as bank loans, commodities, whole mortgages and REITs that are now being offered as collateral.”
Some enhanced cash products were hit hard by the credit crunch. However, Brad Adams, cash and short-duration investment product manager at Northern Trust, cautions against tarring all cash products with the same brush. “Aggressive funds have not performed that well in the credit crisis,” he says. “Those funds likely used leverage and when the liquidity crisis hit it was difficult to maintain leveraged positions and assets were subsequently sold into a rapidly declining market.” Adams adds funds that don’t use leverage and/or invest in high-quality, A-rated or better products typically are more in line with their benchmarks.
Although some enhanced cash products may invest in structured investment vehicles (SIVs), not all SIVs are created equal. SIVs generally issue short- as well as long-term debt, the latter being a one- or two-year floating rate, Adams says. The proceeds from the debt issuance are invested in longer-term, higher-yielding, fixed-income investments. SIVs can buy corporate bonds or mortgage-backed bonds on a continuum from AAA to junk. They all have different levels of back-up lines of liquidity, different tiers of capital, different sources of funding and invest in different types of assets.
Since the investments can be complicated, Adams recommends that institutional investors outsource this part of the investment program to asset managers that specialize in cash management and are capable of better managing risk.
“Liquidity and risk are the preeminent considerations for cash portfolios in today’s market,” Adams notes. New strategic approaches to short-term investing can enable investors to satisfy those objectives while seeking enhanced performance from their cash positions.
Investors face a dilemma when seeking to maximize returns on their short-term cash. At a time when cash positions are at near-record levels, the average yield on traditional investments has been declining.