Laura Blows discovers how investors found cash a safe haven during the recent period of market volatility, and how this in turn affected the way cash is managed by investors
The recession may be officially ‘over', but fears of a double dip recession continues and market insecurity remains. In these uncertain times there's still one asset investors are counting on to remain stable - good old reliable cash.
Its low returns and steady nature means cash may hardly be the most exciting investment opportunity, but boring is just what some pension funds are looking for at the moment.
Increased security
Cash provides safety and liquidity in return for low yields. All pension schemes require some operational cash holdings, be it for paying out benefits or as capital for other investments. A typical cash holding may be about 5% of a pension fund portfolio, generally held in overnight cash accounts.
However, the last couple of years have seen pension funds increasingly use cash as a tactical allocation.
F&C head of asset allocation Paul Niven says: "Market data shows there are reasonably larger amounts of cash holdings than previously. These high cash levels reflect short-term nervousness and uncertainty towards market outlook.
"Trustees are possibly holding back on certain investments, thereby allowing cash to build up naturally, due to concerns about volatility. Pension funds are now less concerned about being fully invested at all times."
This has affected the way pension funds manage this cash. BNY Mellon director of institutional liquidity sales Marcus Littler says: "If we went back a couple of years, cash was a relatively benign part of a pension fund's portfolio. What has changed in the last 18 months has been a bit more due diligence, acknowledging that it's an asset that needs management."
Diversifying into MMF
As a result of this focus on cash management, there has been an increased inflow into money market funds (MMFs) by institutional investors.
MMFs, or liquidity funds, are defined by The Institutional Money Market Funds Association (IMMFA) as "mutual funds that invest in shortterm money market instruments. These funds allow investors to participate in a more diverse and high-quality portfolio than if they were to invest individually".
MMFs comprise constant net asset value (CNAV) money market funds that are issued with an unchanging face value, such as £1 per share. Variable net asset value (VNAV) money market funds with shares that change daily are also available.
All IMMFA members' funds must have a triple A fund rating. Its voluntary code of practice also places restrictions on how the cash is held. IMMFA chief executive Gail le Coz gives an example: "For liquidity, 5% of the whole fund must be in instruments that mature the next day and 20% must be in instruments that mature within the next week."
According to IMMFA, an average MMF portfolio from June 2010 consisted of about 35% commercial paper, 27% certificates of deposits, 17% time deposits, 9% floating rate notes, 9% repo and 3% treasury.
Despite MMFs having existed for decades, assets in MMFs have increased significantly over the past few years. By June 2010 IMMFA members held about €450bn (£375bn) in its funds.
Henderson Global Investors director of institutional business David Morley attributes the growing interest in MMFs to concern over investment security, as "no one wants to put all their eggs in one basket".
Most MMFs are measured against a seven day cash deposit benchmark, Morley adds, so despite the diversification MMFs should at least match the return from keeping cash in an account for seven days.
The benefit to this, Prime Rate Capital chief executive Chris Oulton says, is "the huge amount of credit exposure makes it a more comfortable place to be in as even the largest banks can fail".
Lehman Brothers collapse in 2008 certainly affected MMFs - in the US some ‘broke the buck' and fell below the $1 set share price, losing clients money and sending shockwaves throughout the market.
MMFs also suffered from bad press early in the millennium, particularly in the US, due to some funds investing in asset backed securities to boost returns. The result, LGIM head of cash management Jennifer Gillespie says, is everyone became wary of cash funds.
However, the period where people were nervous to invest in cash funds containing any kind of risk has passed, Niven says.
Many MMF fund managers are being increasingly careful in their investment choices though. Le Coz says: "Since 2008 cash fund managers have been really decreasing the amount of risk they've been taking with their fund.
"So MMFs are already at the lower end of the risk spectrum, but now the risk has been reduced even further."
Gillespie has also noticed the investors themselves derisking even further by entering into what is considered virtually risk-free treasury MMFs, which exclusively invest in government securities.
Lessons learnt
Over the last 18 months, investors have been asking more questions about their cash funds. Littler says: "It used to be quite benign with maybe the odd question. Now we offer group dial-ins with fund managers and investors and we see a lot more of our clients."
Delving into the MMF and understanding its investment strategies could help avoid another backlash against MMFs investing in unsuitable credit risk instruments
Gillespie explains: "The whole idea of liquidity assets is that the asset stays stable at £1. So if there is a comparatively large return then you should ask why. Is it from credit curve or duration calls? You need to speak to the fund manager and ask how they make decisions, what processes they have."
Now that we are slowly coming out of the recession, investors can take more time to explore their cash investment options. BNY Mellon executive vice president global short duration strategist Laurie Carroll says: "During the height of the crisis people moved into cash very quickly from fear, without looking at the long term consequences. Then afterwards they were concerned about not getting good returns."
Investors may have moved into MMFs out of necessity due to the economic downturn, but Carroll hopes that the benefits of diversification will continue to resonate.
She says: "The need for diversification, instead of putting everything into one bank, seems to be the thing investors forget after every crisis. At every crisis they diversify but at the next downturn the same issue arises-the need to diversify. However, this recent crisis was historic so I'm optimistic that long-term lessons have been learnt."
In contrast, Niven expects these levels to decline over time as cash levels grew due to market concern and hesitation, especially "as history shows that people's memories are quite short".
However, as MMFs consistently offer security, diversification and liquidity - something pension funds always require from their cash whether there is a recession or not - they may still continue to grow.
Oulton believes so, saying: "I expect to see the industry grow strongly over the next five years. What these funds represent is an actual treasury management service. These skills are now seen as more specialised than people were previously aware."
