Why cash has come into its own

One of the many effects of the crisis has been to push cash management up the agenda, says Christopher Andrews

Historically, pension fund cash management has been carried out almost as an afterthought. A fund's cash holdings were simply entrusted to a custodian, or discretion was given to an underlying equity or bond manager to deal with any excess cash that was on hand.

The monumental financial events of the past few months, however, have put cash management in a completely different light. Afterthought administration of cash holdings is off the agenda. Pension funds are now keeping a very close eye on their dollars, euros and pounds, as the fate of the Icelandic banks and Lehman's has crystallised awareness that cash comes with its own risks.

"I think what we've seen in the last few months is that pension funds have been removed from a position where they didn't really pay that much attention to their cash, to a point where they now see it as something they should be paying a lot of attention to," says Stuart Jarvis, research director of the Client Solutions Group at Barclay's Global Investors.
In the current economic climate, where beyond returns liquidity has become a major concern, European pension funds are not only paying more attention to how their cash is being managed, but are also holding onto a lot more of it. Traditional cash holdings have generally been in the range of zero to five per cent, tending towards the lower end of that spectrum. However, a Reuters poll of institutional fund mangers, published at the end of October, found that cash allocation had risen to 6.3 per cent, a four-and-a-half year high, up from 5.8 per cent in September and 3.8 per cent in August.

In fact some pension schemes, according to Martin West, director, actuarial and investment services at Gissings, now have as much as 20 per cent of their funds in cash. "There are a number of pensions schemes that I look after that have got significant cash holdings," he says. "Given the uncertainty as to where to direct investments at the moment, I think we're going to see cash becoming a much more widely used asset class. Whether that continues into the longer term I don't know."

Putting money to work

The state of longer term allocations, of course, depends on market recovery, as well as overcoming increasing risk aversion in the light of decidedly under-performing traditional asset classes. It is worth noting that in the last year the only asset classes to have actually posted positive returns have been cash and nominal government bonds.
Despite risk aversion and liquidity issues, this has made increasing cash allocations even more attractive says Chris Oulton, CEO of Prime Rate Capital management as, in simple terms, it is the one bit of portfolios that isn't moving. "So it's a bit like being on a ship where everything else is flying around, and you make sure you tie up tightly the one thing that you think is going to stay put."

So with upwards of 20 per cent of some pension funds in cash, what should be done with those piles of money that are sitting around? Two options being given the most consideration are, firstly, to leave it on diversified deposit or, secondly, to be a little more creative and make use of money market, or cash, funds.
Keeping cash on deposit is pretty straightforward and generally safe – assuming the bank that is holding the funds doesn't go bust. Unfortunately, as recent months have shown, nothing is guaranteed. As such, West advises that it is sensible to diversify cash holdings across several banks to hedge the risk. "I think if you stick to the high street banks in the UK, for example, three of which are partly nationalised now, you have in practice got a very high degree of security with those accounts."

Deposit accounts indeed remain the favoured home for cash, says Anne Read, associate director, corporate communications at Fidelity, at least as far as corporate treasurers are concerned. But, she says, treasury style money market funds are increasingly becoming a normal tool, and less of a niche product.
"Not only does a well managed fund give diversified exposure to a large number of issuers which reduces the risk of default," she says, "but it can also save an investors time and administration when considering which counter-parties to invest with."

Of course the main advantage of a cash fund over a deposit account is the potential for increased yield. "Unlike a deposit account the fund manager's role is to seek the best deposits and money market securities on the market, within the fund's guidelines of offering high levels of security and same day liquidity," says Read, "and the fund's performance will be measured against a cash benchmark – usually one based on Libor or Euribor."

According to Jarvis: "You're typically going to get a higher yield, because you're lending to corporates or financial institutions over a period which might be a few months rather than overnight. So you've got the duration and you've got the credit exposure." Liquidity funds, he says, provide a source for overnight cash, with overnight interest rates being the typical benchmark, and very short term instruments providing that yield. "And then for more strategic holdings you're prepared to increase the duration to three or six months or even longer."

Oulton says that Prime Rate's current yields - and this is partly because their funds hold legacy assets bought before dramatic interest rate cuts had come in – are around five per cent for euros and 4.95 per cent for Sterling, a big
pick up over the cost of day to day money.

"There is also a benefit generated by the fact that there are institutions selling assets, at what might be described as distressed levels, because most people at the moment are trying to raise cash," he says. "We have a cash fund, the opposite way around. We have a lot of cash, so we're in rather a nice position."

Virtues of vanilla
Oulton believes that as these cash funds are instant access, there is actually no reason to leave anycash on call. "You just use this as a mixture of your call account and your deposit account." He says that the advantages are demonstrated by the combination of yield pick up and that instant access, as well as pooling liquidity and diversifying across investors.

"And by virtue of the fact that a lot of the fund is going to be held in day to day cash anyway to fund redemptions, and the rest is going to be held in highly liquid securities which can be sold if necessary to generate additional cash to fund redemptions, you've actually got the best of both worlds."

However, as West points out, cash funds are not guaranteed. Underlying assets, such as short term Gilts, are capable of going down in price, and there are potential default risks on commercial paper, for example. "So there isn't an absolute guarantee on those types of cash funds, but there normally is an absolute guarantee if you've got money on deposit with the banks."

Indeed, a report published by UK newspaper The Observer in late October found that more than one in five money market funds available to retail investors had gone down in value over the previous three months, largely do to the underlying use of asset backed securities which lost value in the wake of financial turmoil.

This means if a pension scheme is going to go the cash fund route, it is worth finding out what the underlying assets for the fund actually are, and it is probably worth sticking to those with a 'plain vanilla' philosophy. As Jarvis points out, and this applies to both cash funds and deposit accounts, the word of the day is diversification. "The way that we manage and consultants are recommending that cash be managed is, don't put it all with one party, and make sure you've got diversified exposure across the whole range of counter parties or credit issuers."

Top money market considerations from Prime Rate:
1) Trust no-one – safe assumptions can no longer be made and a single party cannot assure that money invested is 100 per cent safe.

2) Diversify – exposure to any individual issuer needs to be minimal and spread over a range of different credits.

3) Choose wisely – cash is now seen as a specialist asset class requiring specialist skills, so exercise caution by choosing an expert manager that focuses purely on cash management.

4) Ensure clarity – make sure that the composition of the portfolio and performance of the fund is transparent.

5) Check integrity – remember
that product integrity is derived from appropriate portfolio construction and risk management disciplines.

WRITTEN BY CHRISTOPHER ANDREWS, A FREELANCE WRITER