Rethinking Cash Portfolios

Historically, institutional investors have paid less attention to the short-term cash component of their portfolios, but market dynamics have combined to force investors to re-examine how their cash assets are managed.

Many people consider the 2008 financial crisis as the point at which investors began to take a second look at their cash portfolios. The Reserve Primary Fund “broke the buck” in September 2008, sparking a wave of assets flowing out of money market funds, a popular investment vehicle for cash allocations, and into federally insured bank accounts bearing little interest.

Money market funds continue to face a number of constraints as ratings agencies consider downgrading the debt of many U.S. and European banks (making their bonds unsuitable for most conservative funds), as well as various reform proposals and new regulations. (See "The New Money Market Fund Reality" below.)

"What these widespread proposed reforms and new regulations have in common is that they are all designed to increase readily available cash, or reduce dependence on funding — and this is true not just for money market funds, but also banks and corporate balance sheets," said Ali Bleecker, deputy managing director of fixed-income investment management at Northern Trust.

Other factors also have emphasized the need for a fresh approach to managing short-term portfolios. Equity market volatility and extremely low long-term bond yields have increased the flow of money into cash accounts as a safe haven. Cash can operate like an insurance policy for unforeseen events, but the premium on the policy has increased dramatically as short-term interest rates have remained near zero.

“There is a lot of cash sloshing around out there. Some banks are so flush with cash that they are actually charging clients to leave it on their balance sheets,” said Scott Warner, head of Northern Trust's fixed-income product management for the Americas. Given the current environment, traditional short-term cash investment strategies are not going to provide the performance that investors have come to expect, he added.

“We are now in the fourth year of extraordinarily low interest rates. The Federal Reserve dropped the Federal Funds rate to between 0 and 25 basis points in 2008 — and it is currently forecasting no change to this target until the end of 2014,” Warner said. “This means we are headed for a fifth year, and possibly more, of near-zero interest rates on short-term investments.”

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A New Approach to Cash

Although the extended period of historically low interest rates makes a segmentation strategy appealing, the approach offers advantages in all market scenarios. `

“Investors naturally become frustrated when yield is hard to come by. Furthermore, they feel helpless as regulatory changes keep cropping up and changing the goalposts,” said Peter Yi, director of short-duration fixed income at Northern Trust. “You can't control regulatory or market changes, but you can control an intelligent approach to investing.”

For example, investors could consider the various purposes or intended uses for their cash, then create portfolio segments or “buckets,” each with their own liquidity, risk and return criteria. This approach would enable investors to take advantage of higher yielding short- and medium-term instruments where appropriate, thus enhancing the performance of the overall portfolio.

By looking strategically at cash, investors could increase incremental returns while maintaining an appropriate level of risk.

Short-term cash portfolios generally can be separated into three broad categories:

• 1) Operational: This is the amount of liquidity required to manage day-to-day needs. This cash should be invested very conservatively, with a weighted average maturity (WAM) of between one and 30 days and a focus on government debt and secured investments. Your goal with the operational segment of your cash is safety and liquidity, not returns.
• 2) Reserve: This cash is allocated for short-term funding needs for which you might receive one to seven days' notice. Reserve cash still should be invested conservatively, but you can consider a slightly longer average duration of between 30 and 90 days, depending on how accurately you are able to forecast these needs. Moving further out on the duration will open up the possibility for investments in financial and corporate debt with maturities beyond one business day.
• 3) Strategic: This portion of the cash portfolio would be designed to provide the highest possible yield while maintaining principal preservation as a primary objective. The average duration of these investments generally should be between six months and 18 months, depending on your risk tolerance and cash flow projection acumen. These investments have a high credit quality and will incorporate a broad range of financial, corporate and securitized debt securities.

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The Benefit of Active Management

Although the amount allocated to each bucket would depend on the specific needs and objectives of the investor, segmenting the short-term portfolio based on cash flow projections could reap significant benefits

By looking strategically at cash, investors could increase incremental returns while maintaining an appropriate level of risk. For example, the cash in the “strategic” bucket could be invested in an ultra-short duration strategy, which uses active management and a slightly longer duration to enhance yield.

“You can effectively reduce the cost of holding cash,” Bleecker said. “Say, for example, an institution has $1 billion in cash and they divide the portfolio into thirds. The first third, transactional cash, might return almost nothing. The second third, reserve cash, could return 15 basis points, while the remaining third, strategic cash, might yield 25 basis points. That means the total portfolio would average a return of 13 basis points — or $1.33 million — rather than the zero return if the investor had done nothing.”

Ultra-short portfolios have a goal of generating higher total returns, while seeking to limit the risk to principal. By constructing high-quality portfolios through an investment process that emphasizes thorough credit research, broad diversification across sectors and risk management, ultra-short strategies target total gross returns of 25 to 50 basis points over money market funds across a market cycle.

By constructing high-quality portfolios through an investment process that emphasizes thorough credit research, broad diversification across sectors and risk management, ultra-short strategies target total gross returns of 25 to 50 basis points over money market funds across a market cycle.

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Outsourcing Solutions

Given the challenging environment for cash investments, an actively managed strategy does require additional expertise and resources, particularly in analyzing the shrinking supply of appropriate short-term vehicles and managing new risk exposures. One way to obtain the necessary expertise is through the use of an outside investment manager.

A strong risk management and compliance process includes the following elements:

• Exposure controls at the security, portfolio and organizational level;
• Pre- and post-trade compliance checks against guidelines; and
• Periodic peer and independent reviews to ensure consistency and quality of process.

Historically, institutional investors have not paid much attention to actively managing pools of cash. The current investment climate, however, puts much greater pressure on them to increase overall returns. By thoughtfully assessing future cash flow needs, investors can use a segmented approach to actively manage their short-term portfolios to produce higher yield.

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