time to cash in

Pension funds and others with cash to spare may look first at money market funds to park savings, but hedge funds are also seeing the benefits of using these vehicles

Achieving competitive returns within a risk-controlled framework is now as important for cash as it always has been for investments in other asset classes

Squeezing every last basis point of return out of portfolios has never been more important - but it is equally crucial to achieve this Holy Grail in a risk-controlled manner.

This investment climate is principally a function of the intense competition in the financial services industry, combined with a protracted equity bear market and lower return expectations. In an environment of double-digit annual equity returns, the return generated by a 5% cash weighting in a portfolio seemed less important - today, this is simply not the case.

Expectations have been reset and part of this shift has been the growing recognition that the returns generated by the cash component of a portfolio can mean the difference between outperforming client expectations, or disappointing them.

So how do you achieve the best risk-adjusted returns from cash assets? Money market funds are certainly one answer.

Keeping it cash

The volatility in investment markets and a sharp deterioration in the credit quality of borrowers have also meant more attention being paid to risk and return. Both these factors have led to a heightened awareness and use of money market funds across Europe. Cash is increasingly seen as an asset class in its own right, and one that requires specialist expertise to achieve liquidity, security and low volatility of returns.

Money market funds provide an efficient tool for managing cash balances. Clients own units in a fund and their cash is amalgamated with other investors' holdings and traded under set guidelines.

Typically the funds are AAA-rated by one or both of the leading rating agencies, Moody's Investors Service and Standard & Poor's, which reflects the high degree of security provided by these funds. They also offer investors same-day liquidity. The investment strategy will be set to achieve a return in line with a benchmark - typically seven-day or one-month deposit rates after the deduction of all costs. The types of instruments in which investments are made include deposits, commercial paper, certificates of deposit, fixed and floating-rate notes and asset-backed securities, and the weighting to each instrument type will be determined by guidelines and should reflect the liquidity needs of a fund's specific client base.

So what are the advantages of using money market funds to manage cash? Achieving competitive returns within a risk-controlled framework is now as important for cash assets as it has always been for investments in fixed income or equities.

Improving risk diversification

Money market funds provide a number of advantages against traditional investment methods of cash assets, the first of which is better risk diversification across top-quality issuers. In order to be awarded an AAA rating, a money market fund is required to have no more than 10% of the fund invested in any one issuer. Each investment made also has to be of a minimum credit quality - generally A1 or P1 for short-term investments.

Improved risk diversification over a bank deposit is easily achieved, with one trade providing exposure to a large number of highly-rated issuers, regardless of the size of the trade. Large, well-diversified funds typically have anything from 75 to 100 separate issuers represented, which reduces the exposure of the fund to any one issuer name or sector.

The larger fund managers will also have credit analysts who focus purely on cash investments, which means investors benefit from the credit-analysis resource. Managing exposure to banking and corporate sectors requires full-time, specialist credit analysts who can assess the changing risk profile of individual borrowers.

They have to take account of factors such as macroeconomics and how the financial strength of banks and corporations will be affected by the global economy. They need to consider sector-specific issues such as whether any deterioration in a sector is temporary or whether it represents a significant long-term change in the economic profitability of a part of the economy. Finally, there are firm-specific issues. Everyone wants to avoid the next Enron, but it is not always easy to see where the next big corporate risk will come from.

The overall aim is to ensure cash portfolios reduce their exposure to sectors and individual borrowers whose risk profile is deteriorating. Investors who come to cash as a safe-haven asset will not want to discover their cash holdings are invested with banks and corporations that are over-exposed to a wide variety of market risks. In the current environment, with an exceptionally high level of credit downgrades (see graph, left), this is one of the most important skills for a fund manager to provide.

Excellent liquidity

Another advantage with money market funds is their excellent liquidity. The AAA funds offer same-day liquidity allowing investors to move money in or out daily, as if they were overnight deposits, but the return on the fund after fees is more like a one-month investment.

The fund will be structured to provide a balance between liquidity and yield enhancement. Products such as overnight deposits, repo (sale and repurchase agreements) and certificates of deposit provide same-day liquidity while products such as floating-rate notes and commercial paper provide yield enhancement to the portfolio. Larger funds with a well-diversified client base are better able to provide liquidity without impacting fund performance for the investors remaining in the fund.

Money market funds also offer improved returns without compromising capital security or liquidity. The AAA rating of these funds implies the rating agencies view them as a more secure investment than placing a deposit with most of the banks in the market.

The structure of the funds means liquidity is available on a daily basis, without having to maintain all cash on overnight deposits. In addition, the fund manager can usually attain better rates and reduced transactional costs through the superior buying power of placing large trades. This generally means a higher return can be achieved.

Finally, money market funds offer the advantage of improved risk management. There are four principal sources of risk that a manager needs to address with money market funds: market, liquidity, credit and operational risk. A money market fund manager with a large pool of cash assets under management is able to justify the resources necessary to provide the highest quality investment managers, credit analysts and systems required to manage the risks.

In short, pooled cash funds appear to offer investors the double benefit of better returns and lower risks. The growth in assets invested in money market funds reflects the acceptance of these products and their advantages over other money market investments.

In Europe, there are now around 25 providers of money market funds in sterling, US dollars and euros. Assets under management have reached over $150bn across the three currencies and graph 2 (above right) shows the growth of the European money market fund industry. These figures refer only to the standard AAA-rated money market funds managed by members of the Institutional Money Market Fund Association (IMMFA).

The assets in these funds are concentrated in a handful of firms. A quick look at the 19 sterling funds currently offered by IMMFA members shows funds range in size from around £6.5bn to as little as £18m. The three largest funds account for over half of the £27bn of assets and the top five funds manage 75% of the assets. The benefits of good liquidity and economies of scale the larger funds provide are therefore only available through a small number of managers.

So how do different investors make use of money market funds? Attracted by the security, liquidity, ease of use and competitive returns, corporate treasurers and pension funds have driven money market fund growth in Europe. We are now seeing an increasing range of investors from across the financial services industry looking to take advantage of these funds to add value to their business.

Use by hedge funds

For example, rather than leaving cash as collateral on account with their prime broker, hedge funds are increasingly using money market funds to ensure they are squeezing the last basis point of return from their cash. Money market funds provide them with competitive returns compared with what they would earn on account at their prime broker, while providing the daily liquidity that hedge funds require to cover margin calls or to allow efficient asset-allocation changes. These benefits are provided through one trade, ensuring hassle-free investment of their cash.

Custody banks have traditionally used their own in-house money market funds for clients who are return-sensitive and do not want their cash left on an account earning a poor return. However, often the fees charged by the custody banks on their money market funds have been higher than those charged by other banks and asset managers.

Custody banks are now looking to offer 'best of breed' funds across the currencies and to broaden the choice of funds available to their clients. This has led to custody banks offering the funds of other providers alongside their own products, with the custodian then being able to offer their clients funds from the premier providers of money market funds.

Multi-managers are also turning to specialist cash managers and money market funds. The funds provide the multi-manager with an ideal vehicle for any long-term weighting to cash and a vehicle in which to 'park' cash during an asset-allocation change. The funds are designed to provide the multi-manager with an attractive return and low volatility with the flexibility of daily liquidity.

Money market funds can also enhance the efficiency of asset-allocation changes. Using these funds reduces the transaction cost involved in an asset-allocation change. If cash is invested in a segregated portfolio of money market assets, raising liquidity would incur a cost due to the bid-offer spread on selling assets. There is no bid-offer spread on the price of a money market fund, thereby negating any cost of raising liquidity. Multi-managers that provide an attractive option for investing cash for a client who is deciding on an asset-allocation mix will increase the likelihood of keeping a client's money pending any decision.

Liquid and secure

Asset managers who do not have an in-house management resource are also finding money market funds useful. For example, asset-allocation decisions that result in an increase in cash weightings make finding an efficient home for the cash all the more important. Using a specialist cash manager allows the asset manager to take the benefits from outsourcing, while ensuring their clients' cash is managed efficiently with high security and ample daily liquidity. In fact, many organisations that receive cash as collateral in the course of their usual activities could benefit from using money market funds.

Private banks that offer their clients an investment management service are also turning to specialist cash managers and money market funds to manage their clients' cash. They are able to offer their clients a product that provides attractive returns, while recognising the need for liquidity and capital security.

In an environment of increased volatility of returns and investor risk aversion, private banks can offer a product where preservation of capital and low volatility of returns are the primary objectives, providing a safe haven for their clients. The specialist cash manager is able to provide this in a risk-controlled framework with competitive returns. BGI currently provides cash investment management expertise to a number of private banks.

In all these examples, the underlying clients are gaining the benefits of the enhanced returns, excellent liquidity and high security inherent in money market funds, alongside the expertise, economies of scale in trading and access to credit research from the specialist cash manager. Money market funds allow a broad range of users to add value for their clients.

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