In a class of its own

Without cash, pension scheme investment portfolios would not be able to operate. Most schemes begrudgingly allocate around 5pc of their investments to what is often seen as a non-performing asset.

And so, while such an allocation represents a significant proportion of a pension fund’s portfolio, cash is all too often in danger of being forgotten about. Trustees might be right in focusing more of their attention on longer-term strategic asset allocation, but sweeping 5pc of their portfolios under the carpet can be a major mistake.

Some industry specialists would go as far to say that cash should be viewed as an asset class in itself. HSBC Investments’s global head of liquidity Peter Knight is not so sure. But while cash should not be viewed in the same way as equities, fixed income and other strategic investments, he argues, it has a very important role to play.

Knight says: “Cash is there for different reasons. Cash is not an asset class in terms of investment, but it is important in terms of making sure that the portfolio performs properly.

“In other words, it is the equivalent of working capital in a pension fund portfolio – it is there to keep the cogs moving. With investments and disinvestments, the cash is there in the middle of it.”

There are a number of reasons why schemes might hold cash, as Watson Wyatt senior investment consultant Russell Masding highlights:
- Trustee bank accounts: The working cash balances under direct control of the trustees, or their administrator, either set aside to ensure the payment of benefits or the contributions received prior to investment in other assets.
- Cash balances held by a scheme’s investment managers: Inevitably, most investment portfolios contain an element of cash that the investment manager has not invested elsewhere, or income receipts that have not yet been reinvested. The sums involved can be fairly substantial, particularly when a fund employs multiple managers.
- Strategic cash investments: Many defined contribution funds, and some defined benefit funds, make a strategic allocation to cash as an investment in its own right.
- Cash backing derivative strategies and collateral: As derivative strategies become more common, the amount of cash either held to back these strategies or received as collateral is set to increase. The sums involved can be particularly large.
- Cash awaiting investment in other asset classes: Some funds have large cash balances which are held as future funding for asset classes such as property and private equity.
- Cash resulting from securities lending activities­: Activities such as securities lending can result in large pools of collateral cash that require management to ensure they outperform the implied financing rate. Most UK schemes do not currently accept cash collateral as part of their securities lending programmes.

According to Barclays Global Investors principal and head of European cash management Jonathan Curry, pension fund weightings in cash have been increasing, and this is leading to a greater amount of attention being placed on how the cash is being managed.

He says: “Historically, other than in very mature schemes, cash weightings have been very low; schemes typically haven’t carried a lot of cash. If they have, it has typically been for very short periods during a transition or an asset allocation transaction.

“So, I think for the majority of pension schemes it hasn’t been a big focus. If you consider the risk profile of cash investments combined with their low weightings, it makes sense – why would you spend too much time on it when you are investing in assets classes that have significantly higher risk profiles and higher weightings in the pension scheme itself?”

This is beginning to change, Curry argues, because schemes are generally holding more cash, and this trend is in part driven by the increasing prevalence of derivative strategies that require the liquidity offered by cash. An obvious example is liability-driven investment.

Curry explains: “If a pension fund is taking exposure to interest rates and inflation, synthetically via swaps, then typically – although not in all cases – there will be cash collateral backing those positions. Sometimes it will be physical bonds, but in a lot of cases it will actually be cash.

“There is an increasing use of derivatives right across the asset classes – in equity strategies, in fixed income strategies and also in certain asset classes where taking exposure synthetically is more common. Exposure to the commodities market, for example, is taken synthetically, via futures typically.”

While there is a growing demand for cash due to the increasing use of derivatives across asset classes, Curry believes there is a particularly prevalent example in the LDI space.

He says: “With that, we would expect there to be an increase in the interest in cash management, both from consultants and pension fund trustees.”

Masding certainly agrees that the growing use of cash “as a backing asset for derivative strategies” is one of the two main factors driving a greater awareness of the importance of effective cash management – the other being the “increased sophistication of pension funds generally”.

Risk tranches
It is not just within the UK pension fund space that effective cash management is becoming an increasingly important function. As Knight highlights, “the world is completely awash with cash nowadays.”

In fact, there is estimated to be around £40trn invested in cash worldwide. The US corporate space is a prime example of how important cash management has become, with corporate cash balances today representing roughly 7pc of market capitalisation of the top 500 American companies (S&P500).

Knight says: “The biggest companies in the world are holding 7pc of their capitalisation in cash, which is far beyond what they need for working capital requirements. So there is just a lot of cash sloshing around the world.”

Consequently, large companies are ensuring that their cash investments are managed effectively. Schemes are starting to follow suit, but firms are leading the way. In its basic form, this entails producing a cash forecast, analysing cash flows and dividing them into “risk tranches” or “buckets”.

Cash flows can be separated into the following three tranches:
- Operating cash: This is the cash that needs to be on hand with instant liquidity to satisfy the demands of the pension scheme.
- Core cash: This section requires less liquidity and is likely to be dipped into every three to six months.
- Strategic cash: Cash in this tranche will be held for longer than 12 months. This may represent a strategic allocation, but for most schemes will represent a very small amount.

Knight explains: “The most important thing for any organisation, whether you are a corporate or a pension fund, is to forecast your cashflows. That is the most important thing you can possibly do. That is the biggest value-added, because with the benefit of forethought, you can look to maximise your returns.

“Producing a cash forecast is very important. Certainly in the corporate market it is much more prevalent than you would see in the pension funds market. In the latter is thought of more as a passive asset that is used for other things, so forecasting is not necessarily a discipline that is prevalent. But with a little bit of work you can actually add a lot of value to your cash.”

According to JPMorgan Asset Management’s European head of liquidity Kathleen Hughes, the trend of schemes looking to manage cash in a similar manner to companies may be helped by sponsoring employers and their treasurers, which are becoming increasingly concerned with issues such as scheme underfunding.

She says: “The treasurer’s job is really to be focused on managing the cash reserves of the corporation and risk management. I think the treasurer brings those two elements to the pensions side.

“I think treasurers offer another way to look at cash – looking at it in different buckets, where this section needs to be highly liquid cash, or this can be kept a little bit longer.”

Once a pension scheme has divided its cash flows into risk tranches it can identify any surplus cash that can be used to maximise returns – i.e. cash that does not need to be highly liquid.

The biggest danger is that schemes are leaving all their cash investments with their custodians without investigating what the custodian is doing with it.

Knight urges trustees to ask their custodian what it is doing with their cash. He says: “It might just be sitting on low interest bearing accounts. We still see a lot of that even though it has been 20 years since money was more actively managed in this sector.

“We still see large amounts of money sitting on custodians’ bank accounts just because the question hasn’t been asked of the custodian, by the trustees or the manager, as to what they are doing with their cash.”

Hughes agrees. She says: “A lot of the time, trustees may just leave the cash aspect of a scheme either with the investment manager or leave it up to the custodian. The custodian may sweep that into a product that is not yielding a good return for the pension fund.

“It is worth doing a couple of things. One is not allowing your equity manager to manage the residual cash – you should at least get that down to the custodian level. Then you should talk to your custodian, explore options and not just allow it to be passively invested.”

Money market funds
Most cash held by schemes will require a high level of liquidity, often next-day. To cope with this, schemes have traditionally invested their cash in time deposits or cash deposits with banks.

However, today’s schemes have at their disposal liquidity funds that offer the same high level of security (if not more) as bank deposits, with the added benefits of better liquidity and administrative simplicity.

The most secure liquidity funds are the AAA-rated MR1+ money market funds – their AAA Moody’s rating reflect the highest possible credit rating and lowest sensitivity to market volatility.

MMFs are mutual funds that invest in short-term debt instruments. They provide the benefits of pooled investment, as schemes can participate in a more diverse and high-quality portfolio than they otherwise could individually.

Like other mutual funds, each investor who invests in an MMF is considered a shareholder of the investment pool, a part owner of the fund. MMFs are actively managed within rigid and transparent guidelines to offer safety of principal, liquidity and competitive sector-related returns.

Most schemes are starting to utilise these secure and liquid vehicles. Kelly says: “What pension funds have traditionally done is try to sweep up cash by investing it in primitive vehicles such as time deposits or cash deposits with banks.

“Where we have started to see the pension fund industry pick up on the MMFs is around the fact that AAA-rate MR1+ funds actually provide a higher rating – or the best credit quality – than many of the banks can actually provide.”

Such high levels of security comes down to the huge diversification that MMFs enjoy through pooling investors. A fund might have over 100 issuers, a level that a scheme would find it almost impossible to achieve on a bespoke mandate basis.

Kelly continues: “Institutional MMFs are vehicles that pension funds can buy in one transaction. So, rather than have 10 deposits of varying durations – be it overnight, one week, three months, longer-term in some cases – the pension fund office can buy, in one transaction, several units of the underlying institutional MMFs.

“What that gives them is a huge range of diversification. That one fund is actively managed – in the case of Fidelity’s funds – on a daily basis. Therefore, if your pension fund administration office or treasury function decided to place a deposit for three months, and there was a surprise interest rate hike in the market, the deposit would effectively be three months out in terms of the rate of return it is going to give; whereas the MMF, because it is actively traded on a daily basis, would quickly regear to any of the market situations – especially surprise interest rate hikes.

“It would be able to give a good level of return with the diversification gained from over 100 issuers.”

After security and diversification, schemes are looking for high levels of liquidity when it comes to investing cash. MMFs can provide this as well.

Kelly says: “Diversification is one thing. Liquidity is the next key. Liquidity funds generally have a same-day settlement period, and most of them have a cut-off time that is actually later than what was traditionally known as the core deposit account notice period.”

MMFs are also very competitive. Curry says you don’t need to compromise security and liquidity to gain those competitive returns.

“Some of the economies of scale that you are able to achieve in a pooled vehicle, rather than having it managed on a small segregated mandate, allow you to provide those competitive returns, plus the liquidity these funds typically offer.”

Finally, MMFs offer administrative simplicity. Kelly explains: “The other big factor, in managing cash from a pension fund’s perspective, is that schemes have an operational constraint – they have to look at internal risk, their compliance and assess each of the deposits they are doing.

“There is, therefore, a whole infrastructure that would be necessary for pension funds to do this efficiently, whereas when you buy the institutional MMF you are also buying the professional services of the provider of that fund.

“For example, in the case of Fidelity, we have an investment process, we have research, we have dedicated analysts who look at all of the underlying investments that are being purchased and invested in from the MMF’s perspective.”

Curry sums up MMFs’ appeal: “If you are a cash investor and you are looking for an alternative to deposits, what you are looking for is: preservation of capital (effectively the security that you are going to get your principal back as a minimum); that you can gain access to the money when you need it; that you can get a competitive market return.”

And the appeal seems to be getting through. The Institutional Money Market Funds Association – the trade association for providers of AAA-rated MMFs – reported a record high of $355bn (£177bn) of funds under a management this year – a $100bn (£50bn) increase on 2005.

Curry’s experiences certainly match the figures. He says: “A lot of the major asset managers now have MMFs that they offer their clients. The industry has grown very rapidly over the last eight years. In many cases this is a mainstream cash product now, and I would say it is certainly in the corporate treasury space, insurance companies need liquidity management and, to be fair, pension funds as well.

“Trustees are very familiar with these products. I remember in the late-1990s talking to potential investors about MMFs and the first thing you had to do was tell them what an MMF was.

“It was an education process initially, and now it is has matured – it is less of an education process and more about the individual providers of the funds and what they can offer clients.