Cash as a Strategic Asset

As investors take a more active approach to their short-term portfolios, they must balance the potential for enhanced returns against risk and liquidity considerations.

Cash, a previously under-utilised and overlooked component of most investment portfolios, is a subject of intense focus for many institutional investors. The reason for the increased scrutiny is that investors have become more diligent in their pursuit of enhanced yields. As recent market events have underscored, however, the quest for improved performance also must consider evolving market risk and liquidity parameters.

Institutional investors such as corporations, governments, pension funds, local authorities, insurance companies and hedge funds have diverse investment horizons, liquidity needs, risk/return profiles and volatility tolerances. As a result, an array of investment solutions have been developed to accommodate these considerations as well as to provide an opportunity for increased returns.

“During the past decade, we have seen a proliferation of investment products that reflect growing market demand to provide a broader range of investment alternatives within the cash to short-duration portion of the yield curve,” says Steven Everett, Director of Balance Sheet Assets at Northern Trust. “Investment solutions vary from high-quality money market fund strategies with a constant net asset value to low-duration investment strategies with mark to market risk. Such strategies may employ leverage, greater credit risk and other portfolio management techniques to achieve their performance objective.”

Still, subprime woes, the subsequent credit crisis and potential for a global recession during the latter part of 2007 caused what Everett calls a ‘retrenchment’, with investors and asset managers reducing risk alike. “All of this is reflected in what we have observed in the front end of yield curves,” he says. “There has been an implosion in yields, in large part due to the flight to quality. An increasing share of liquidity is sitting on the sidelines with much less sensitivity to returns than in past years. In the short run, it’s more about safety, and, clearly, government bonds are the safe harbour.”

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The growth of cash portfolios

One reason short-term investment strategies are receiving more attention is that investors’ cash positions have become a more strategic component of the overall portfolio. For example, cash and short-term assets at many corporations have risen steadily during most of the past decade. At the end of June 2007, the S&P industrials had amassed $603 billion in cash and equivalents, representing about 6% of their total market value, according to a Standard & Poor’s report. Growth outside the US has also been strong with Aaa rated money market funds in Europe growing from $1 billion in 1995 to $622 billion in 2008 (Source: iMoneyNet).

The increase in cash positions stems from two trends: four and half years of double-digit earnings (ended in 2007) and the lack of merger and acquisition activity, which for the past couple of years has been dominated by the private sector using cheap capital.

Traditionally, treasurers and chief financial officers have invested cash in short-term instruments, such as commercial paper or money market funds, until the assets were needed for an acquisition, stock buyback or some other corporate purpose. Institutional investors took a similarly cautious approach with their cash positions as they sought investment opportunities in stocks, bonds or other long-term asset classes.

Putting the money to work

Cash can be divided into two basic tiers - daily working capital and reserve or strategic cash. Working capital usually is invested in short-term, overnight investments such as interest-bearing accounts and money market funds. Strategic cash, which doesn’t need to be turned so quickly, can be invested over a longer time horizon, most often in enhanced cash or short-duration products with greater return objectives.

The objective of enhanced cash products is to outperform money funds on a total return basis with modest interest rate, credit and liquidity risk.

Whereas typical cash funds operate with a duration of up to three months, enhanced cash products use investments that might go out as long as a year.

“Enhanced cash strategies actually provide a very appropriate opportunity for pension cash, insurance reserves and foundation cash, and can be used to duration match short-term pension liabilities,” Everett says. “Enhanced cash also can be applied in portable alpha strategies such as a lower-risk portable alpha strategy that backs an equity exposure.”

Meeting investment objectives

The capital markets have not been alone in reappraising risk. While they are making adjustments to the levels of risk premia across asset classes and instruments, investors are taking a close look at the appropriateness of their investment strategies against investment objectives. As this process of risk reappraisal evolves, investment strategies in the short duration space will become more clearly defined, enabling investors to better manage their risk budget. A broader, better defined product array should give investors the confidence and conviction to be more tactical in the management of their cash now and in the future.