Published: January 01, 2013
Managing cash in separately managed accounts (SMA) should be considered by institutional investors as a real option where the benefits of customisation can be realised. Separate accounts can be as unique as the company itself and are completely driven by the objectives and risk tolerances of each mandate. Working with an external manager can provide significant value through a process of consultative dialogue combined with the depth of trading, risk management, credit research, and portfolio management resources the manager brings to the table.
In contrast to a commingled vehicle such as a money market fund (MMF) where the investment objective of the fund is typically described in the prospectus and changes are relatively unusual, SMA investors are able to define their own Investment Policy Statement (IPS) which in effect becomes the roadmap telling an external asset manager how they want their assets to be invested.
In consultation with their portfolio manager the investor will carefully design the IPS, balancing its guidelines and objectives against current and anticipated market conditions. When drafting an IPS, both clarity and flexibility are important. Clear definition in an IPS allows for the development of a mandate that reflects the nuances of the client’s operating model and investment preferences. Flexibility within an IPS allows the asset manager to leverage his or her insights and market knowledge while making investment decisions to achieve the stated objectives of the portfolio. As a fiduciary, the manager is able to assist the investor to ensure due diligence and decisions regarding the IPS are informed and thorough.
The components of a mandate that can be tailored to achieve a given strategy can take the following forms:
LIQUIDITY
Effective forecasting of liquidity needs allows for the best opportunity to achieve excess returns within a cash portfolio. It is therefore important to segregate a company’s cash in order to determine the potential cash available to invest within a segregated account.
In fairly simplistic terms, a company’s cash can fall into three distinct categories:
While still conservative by nature, strategic cash — which typically has a longer investment horizon than operating cash or core cash — might have more of a total return objective which is ideal for placing in a separate account.[[[PAGE]]]
RISK
Risk tolerance is arguably the most important criterion upon which to begin building a separate account strategy. As a first step, company management must determine if the key priority is preservation of capital or maximisation of returns. This determination may be made for cash as an asset class or for each category of cash the company maintains (i.e., core and strategic). As a next step, consider whether, within each category, there is an ability to sustain any deterioration in liquidity. Risk can come in many forms — for example, short-term volatility, technical pressures (supply/demand) or headline risk. The impact on the company’s cash portfolio can differ based on the ability to navigate these variables and the clear determination of acceptable risks.
Conventional investment wisdom suggests that higher returns are accompanied by higher levels of risk. However, there are different types of risk to consider, some of which may be more tolerable than others given the potential reward. Credit risk in particular gets a lot of attention but with the skill, expertise and credit resources an external asset manager brings to the table, a flexible approach to credit risk can generate extra return without compromising the investor’s overall objectives.
It is also worth noting that triple-A rated MMFs are often constrained by regulation or credit rating agency parameters that ensure credit risk is limited to securities carrying the least risky short-term ratings. The SMA structure allows investors greater flexibility in taking credit risk where they feel comfortable and see value.
DURATION
Each separate account should factor in the desired duration strategy for the company’s cash portfolio. By carefully defining a range of permissible maturities investors can take advantage of the current and expected shape of the yield curve. Portfolios can be tailored to maintain adequate levels of liquidity while placing more stable cash into longer-dated securities that may improve the overall return of a portfolio. In the current markets stepping out of the curve the extra few weeks/months past the investment guidelines of a MMF can yield significant increases due to supply pressures in the short end of the curve.
INDUSTRY AND INSTRUMENT
In addition to defining duration and credit quality, investors may seek exposure to or shelter from a particular sector/industry or issuer. An SMA mandate can stipulate industry, instrument or issuer exposure to adhere to a defined investment policy or seek enhanced yields through targeted exposure. Consider for example the yield differential between quality government bills and equivalent bank paper.
BENCHMARK
Benchmarks are selected after the IPS is developed and clearly understood. The benchmark provides a means by which the company and the investment manager can measure performance. Benchmarks should reflect the risk tolerances of each mandate and exhibit a certain level of comparability with the portfolio’s makeup (in terms of type of securities held, asset allocation and duration) in order to convey risk effectively. Benchmarks should be transparent and measurable, comprising well-defined securities with readily available prices quoted on a daily basis.
When choosing a benchmark, consider the impact of your decision on future performance comparisons. Because of the custom constraints and guidelines typically imposed on a corporate cash portfolio, most will often sacrifice yield-enhancement opportunities in favour of ensuring that the company’s larger goals of capital preservation and liquidity are maintained. In contrast, most fixed income credit indices are total return-oriented and may have components that would be inappropriate for a cash portfolio. For that reason, the indices will often generate returns that exceed those of a more conservative cash portfolio. In most cases, a blended benchmark containing elements that closely resemble the separate account’s expected allocation may be beneficial.
To determine the potential benefits of an SMA to your business, you should consider the following questions and discuss them with your asset manager.
1. Have you been able to segment your cash into operating, core and strategic cash?
a. If yes, are there guidelines that can be constructed to reflect each segment of cash?
b. If no, do you have well defined liquidity needs for your cash?
2. How are you managing your cash now? What sectors are you investing in? How far out on the yield curve are you investing?
3. Do you have an existing investment policy?
a. If so, can the policy be modified and what is required to modify the policy?
b. If not, then sample policies can likely be obtained from asset managers
4. Are there sensitivities or limits to realised gains/losses or unrealised gains/losses?
5. What are your reporting requirements? [[[PAGE]]]
*BlackRock internal figure as of October 2012
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