Written by David Adams
David Adams explains how European pension funds are utilising cash for their investment portfolios
Maybe you’re much more socially successful than me, but have you ever been at a party and felt as if you’re the person other people talk to while they’re waiting for someone more interesting to come along? If cash were at a party for asset classes I suspect that’s exactly how it would feel. Cash is the fall-back option, the safe space to which investors retreat when other asset classes are swamped by risk and volatility. It is patronised by those who would suggest investing in more exciting things; seen as the equivalent of keeping your money under the mattress or burying it in the garden. But in reality cash is often a very useful investment tool for pension funds; and it can be used in surprisingly complex ways.
The level of cash allocations among European pension funds rises and falls as financial conditions fluctuate. In the UK, for example, sales into cash funds increased by 28 per cent between the first and second quarters of 2012, up 100 per cent on Q2 2011; then fell back again in the third quarter as investors turned back to equities, property and fixed income (figures from Skandia UK). Overall, though, the longer-term trend in pension funds using cash is curving upwards.
HSBC Global Asset Management UK institutional director Stuart White declares: “We’re seeing more interest in cash as an asset class within pensions. Post-crisis there has been some rebalancing of portfolios and more risk aversion. You’ve probably got two elements: one is the operat-ing cash holding within the scheme – working capital and rebalancing cash – then you have the cash colla-teral associated with LDI [Liability Driven Investment] implementation. The best investment managers will look at both.”
The underlying principles for using cash are unchanged: preservation of capital in a liquid form which will also generate some return. “It is very difficult in the current environment to get invested safely, be diversified and retain a liquid portfolio,” says BlackRock global chief operating officer and head of international cash Mark Stockley. “Net yields on government vehicles are around zero basis points in euros and dollars. The focus among trustees and investment managers is very much on avoiding risks and trying to maintain a small positive return.”
Mercer investment consulting associate Lewis Emmons sees the increasing willingness to consider cash being driven by a number of different factors, including risk reduction and hedging for LDI. Cash funds can also be useful during periods when pension fund invest-ment portfolios are about to be repositioned for a new strategy.
“Up until 2008 many assumed that everything called cash was liquid and gave very little thought to investing in so-called enhanced cash funds which often took a lot of term and credit risk,” says Emmons. “Post-2008 that changed and investors sought safety at the most risk-free end of the spectrum. Enhanced cash funds were dropped from pension portfolios and ceased to be used as Libor-generating vehicles for LDI strategies. The focus switched to the preservation of principal and liquidity.”
But then, he continues, the euro crisis created new challenges. “Chief among these has been a fall in yields to ultra low and even negative levels as a result of the central bank’s accommodative monetary policies and investor flight to quality. We believe that smaller schemes with lower governance budgets are more likely to tolerate this, whereas larger more sophisticated schemes may look to take on more term and credit risk through separate accounts in order to receive more competitive returns.” Or, indeed, any returns at all.
Stockley says one big ongoing challenge for his team is managing euro-denominated cash vehicles and cash investment strategies for clients, because of the difficulty of generating a return. So investors are looking at using cash in different ways. “You have seen cash emerge as a more specialised asset class,” says Stockley. “[Pension funds] will look to have that managed by a specialist cash manager. Pension funds are having to consider looking at enhanced cash, cash plus, or bond-type plans, to ensure they get a better return.”
A growing number of pension funds are also now having to consider cash from a risk perspective in a way they did not in the past, says White, because the banking crisis has brought counterparty risk out into the open. His team has seen a growing number of corporate treasurers using money market funds, diversified across many different underlying counterparties, rather than single counterparty over-night bank deposits. Now he believes the corporate sector’s attitudes are increasingly influencing the pensions sector in the UK, via treasurers who also act as trustees. “We’ve had a couple of examples recently where a scheme has decided to conduct a search for a money market fund manager,” he says. “So risk management for cash on the corporate side has translated into prudent cash management on the pensions side.”
Meanwhile, although treating cash as a complex asset class in its own right should help investors to get the most out of it, it’s always worth remembering some of the other ways cash and currency can be used within an investment strategy, to provide diversification and additional returns.
Record Currency Management CEO James Wood-Collins says its emerging markets (EM) currencies strategy is designed to generate returns based on the underlying expectation that EM currencies appreciate over time, after inflation, relative to currencies in developed markets.
Wood-Collins says Record is also working on a global currency cash approach, probably to be based on a global currency cash fund. “You want a cash investment and some diversification over your base currency, so you identify four different categories of currencies and allocate among them,” he explains. He suggests considering currencies in different categories based on their attributes: hard currencies like the Swiss franc, Norwegian krona or Singapore dollar; safe haven/risk-off currencies like the US dollar, yen, or Hong Kong dollar; ‘relative value’ currencies, including many in emerging markets in Latin America, Asia and eastern Europe; and ‘high yield’ currencies in selected emerging and developed markets such as Australia. Finally, he also suggests investors consider implementing such strategies through a combination of outright foreign cash deposits and domestic cash deposits with forward foreign exchange contracts on top.
“I think there are all sorts of obvious reasons [to use cash] around security and liquidity, but cash needn’t be domestic currency,” he concludes.
But Emmons says that while he expects cash to continue to be used by pension funds in various ways over the next few years, he “would not expect the role of cash to change as much as the way that cash is managed”.
“Assuming, as many do, a protracted period of ultra low or negative yields, it is unlikely that managers will be able to continue to offer stable net asset value cash funds,” he explains. “Also, if the dire economic climate in Europe persists or worsens, the probability of more bank ratings downgrades would impact on managers’ ability to construct diver-sified portfolios of cash investments.”
In the meantime, says White, the gradual change in cash’s image will continue. “The pension managers really are viewing this as an asset class in its own right. It’s fair to say that pension schemes have become increasingly risk averse. From a liability perspective we’ve certainly seen an increase in LDI and consequently money market usage has increased.
“We will see a bit more risk taken in 2013 and beyond, because of the size of scheme deficits, so some cash will be reallocated – but I do see cash holdings at higher than normal levels at the moment and that will continue.”
Written by David Adams, a freelance journalist