Published: May 18, 2011
The face of the cash management industry is changing. Once thought of as a homogeneous, no-risk asset class, the cash market is now recognised as multi-faceted, complex and, to be sure, subject to risk. For corporate treasurers who have yet to establish or have not recently evaluated their existing cash investment policies, now is the time. In this article, we examine the issues surrounding the cash investment policy statement and offer institutional investors some suggestions and best practices for establishing, updating and/or maintaining this important roadmap for managing their company’s cash.
According to the CFA Institute, an IPS “addresses the client’s risk tolerance, return requirements and all investment constraints (including time horizon, liquidity needs, tax concerns, legal and regulatory factors, and unique circumstances). The IPS also should identify and describe the roles and responsibilities of the parties to the advisory relationship and investment process, as well as schedules for review and evaluation.”
An IPS is a document designed to identify the goals and objectives for a company’s investment portfolio(s), as well as allowable parameters for achieving those goals. The document generally contains specific information about a company’s risk tolerance and liquidity needs. The IPS should be broad, yet explicit in terms of interpretation. Generally speaking, an IPS also should be:
Having a documented policy for the administration of the company’s cash is among the most effective means of risk management, serving as a clear and constant reminder of the firm’s goals and ability to tolerate risk. We believe the IPS should be part of every firm’s risk management protocol, incorporated into an annual board review process (typically by the audit committee) and updated on a regular basis. It will be important to determine:
In short, an effective IPS provides a means for communicating the objectives for and permitted level of risk in a company’s cash portfolio. The IPS should provide guidelines for those responsible for management of the company’s cash, whether that be an internal or external manager.
Typically, these parameters should be reviewed in detail with potential managers as part of the due diligence process to ensure that the company and the party(ies) responsible for the management of its cash share mutual philosophies and assumptions, particularly where vague language may exist.
An effective IPS provides a means for communicating the objectives for and permitted level of risk in a company's cash portfolio.
Before developing an IPS, it is important to conduct a thorough evaluation of the company's cash needs and to pinpoint its risk profile. Effective forecasting of liquidity needs and assessment of risk tolerance allows for the best opportunity to achieve excess returns within a cash portfolio.
As an initial step, the appropriate staff should inventory the company’s cash flow forecasts, including payroll, buyback plans and shareholder dividend payments, as well as any other data that could affect the level of cash on the balance sheet, to quantify how much cash is available for strategic investment. Additionally, staff should consider whether there are any company-specific or unique restrictions to be factored into the cash IPS. These might include covenants or bond indentures that may govern permissible investments.
Second, it is important to assess company priorities. To that end, ask the questions: What is the general course of the company and where is cash likely to be deployed (e.g., towards acquisitions, to fund operations or more likely toward capital expenditures)? Answering these questions can help to ensure that the company’s treasury staff, which is responsible for overseeing the corporate cash strategy, is sharply attuned to the broader objectives of the firm. Of equal importance is obtaining a good understanding of the company’s outlook, taking into account the organisation’s view of the economy and the industry in which it functions. When constructing a cash portfolio, it is important to understand how and when the company may potentially need cash. Forward knowledge of a cash need — be it months, weeks or just days ahead — can have a beneficial impact on expected returns. Having a thorough grasp of expected liquidity needs often can provide more opportunity for excess returns with less risk than a broader set of allowable investments in longer or lower-rated securities, but with uncertain needs. [[[PAGE]]]
From there, treasury and finance staff are better equipped to judge the overall make-up of the company’s cash, a central concept when developing an IPS. In fairly simplistic terms, a company’s cash can fall into three distinct categories:
There are many questions to be answered when developing an IPS. Among them:
Each company’s cash investment policy will be as unique as the company itself, factoring in the firm’s liquidity needs, the general state of the industry in which it operates, broader economic trends and the size of the cash pool. The firm’s specific situation will dictate the policy constraints and benchmark for the cash portfolio.
When constructing a cash portfolio, it is important to understand how and when the company may potentially need cash.
While a company’s investment policy ultimately will be customised, there are several important factors that all corporations should take into account when developing a policy. Each of them — risk tolerance, portfolio objective, benchmark and investment manager — is described here.
Risk tolerance
Risk tolerance is arguably the most important criterion upon which to begin building a cash investment policy. 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., operating, core and strategic). As a next step, consider whether, within each category, there is an ability to weather any deterioration in liquidity.
Risk can come in many forms — for example, short-term volatility, technical pressures (supply/demand) or headline risk, to name just a few. The impact on the company’s cash portfolio can differ based on the ability to navigate these variables. philosophies and assumptions, particularly where vague language may exist.
Conventional investment wisdom suggests that higher returns are accompanied by higher levels of risk. However, as noted above, there are different types of risk to consider, some of which may be more tolerable than others given the potential reward. Quantifying such variables can be a difficult task, but considering these questions can help corporate treasurers frame their company’s risk tolerance:
The dialogue surrounding these questions can help ensure that company management is aware of the risks associated with their cash investment policies and the potential consequences of market or industry events.
Portfolio objectives
Based on the company’s risk tolerance, market views and liquidity needs, corporate treasurers are faced with the task of establishing objectives for their companies’ cash portfolios. A portfolio objective can be quantitative (e.g., seek returns that exceed a defined market hurdle) or qualitative (e.g., focus on safety and liquidity). In either case, the objective should be specific enough to guide the company’s choice of investments, but flexible enough to allow the company to take advantage of tactical opportunities that the cash and fixed income markets might present.
This is not to say that a corporation must establish a single objective for the management of its cash. In fact, as stated earlier, multiple objectives are often warranted. Ultimately, these objectives will guide portfolio construction and help the company to appropriately divide its cash assets into operating, core and strategic buckets.
Importantly, any given corporation might have multiple cash pools, each with a distinct purpose, such as those noted above. It is possible, and often more efficient, to manage multiple pools within a single portfolio; however, it is necessary to identify the purpose of and to establish an appropriate investment objective and risk profile for each pool within the context of the overall portfolio.
Ideally, the portfolio objective(s) also should address the question of duration, specifically indicating whether duration should be actively adjusted to remain within a stated range or whether a buy-and-hold strategy is preferred. Typically, targeting a specific duration is better suited to a total return objective, while buy and hold is more often associated with capital preservation. There are ramifications to either approach, as outlined in ‘The question of duration’, below.
According to the CFA Institute, “The investment profession has long recognised that the combination of several investments is likely to provide a more acceptable level of risk exposure than having all assets in a single investment. The unique characteristics (or risks) of an individual investment may be partially or entirely neutralised when combined with other investments within a portfolio. Some reasonable amount of diversification is the norm for many portfolios, especially those managed by individuals or institutions that have some degree of fiduciary responsibility.”[[[PAGE]]]
Common examples of cash portfolio objectives:
A final note: when establishing an objective for cash accounts, consider the accounting associated with capital gains and losses and the tax implications when gains are realised. In most cases, a total return strategy will require more frequent portfolio turnover. This will equate to more accounting entries and the realisation of capital gains that can affect a company’s reported profitability. In addition, if the company is working with a broker who is paid on a per-trade basis, higher turnover will result in an incremental increase in management costs.
Benchmark
A benchmark offers a means for comparing and measuring portfolio performance and risk. Importantly, a performance target is not a benchmark. While a cash portfolio may seek to match the return of a specific industry or peer group average, such as those for money market mutual funds, that alone does not constitute a benchmark.
When choosing a benchmark, consider the impact of your decision on future performance comparisons.
Generally speaking, every benchmark should be transparent and measurable, meaning it should be comprised of well-defined securities with readily available prices quoted on a daily basis. By definition, a benchmark must 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 effectively convey risk.
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 goalsof 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. Considering the impact of your liquidity and risk objectives relative to the benchmark is an essential part of evaluating performance. In most cases, a blended benchmark containing elements that closely resemble the cash portfolio’s expected allocation may be beneficial. This allows you to better match those portions of the portfolio that are intended to be more liquid.
Investment manager
When it comes to choosing an investment manager for a company’s cash accounts, there are generally two broad models — manage the assets internally with the firm’s own staff or hire an external investment advisor. The level of service provided under each arrangement can be quite different, as can the costs.
Given the resources and expertise required, internal management is most commonly seen with companies that manage very large, core cash portfolios over a long time horizon. Typically, in this model, internal staff work with a broker (or series of brokers in an effort to achieve more competitive.[[[PAGE]]]
Every IPS should factor in the desired duration strategy for the company’s cash portfolio. Most often, this will be a choice between targeting a specific duration or a buy-and-hold approach:
An external management model generally involves a registered investment advisor (RIA), a professional investment manager who has the authority to participate in the creation, execution and maintenance of the company’s cash investment policy. By definition, RIAs serve as fiduciaries for their corporate cash clients. While some brokers act as portfolio managers with discretionary trading authority over a company’s cash accounts, they may not be RIAs and are not required to act as a fiduciary for clients.
For many firms, hiring an investment advisor to manage some or all of their cash has become a logical move given the intricacy of today’s fixed income markets and cost-conscious managements’ focus on establishing key strategic partnerships. In any case, the same criteria should be applied whether considering an in-house or external management arrangement.Questions to consider include:
Corporate treasurers might consider the following points to assist in making a well-informed decision regarding the most appropriate type of management for their company’s cash accounts:
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Each cash IPS will be unique in its details. However, the basic components are likely to be very similar across firms. It is important to carefully evaluate each component of the IPS to rule out the possibility that related guidelines may contradict one another. In addition, corporate treasurers should identify the particular risks they are seeking to control, and determine how to evaluate those risks, in constructing specific guidelines. The following is intended to illustrate the composition of a typical cash IPS. Conventional investment wisdom suggests that higher returns are accompanied by higher levels of risk. However, as noted above, there are different types of risk to consider, some of which may be more tolerable than others given the potential reward. Quantifying such variables can be a difficult task, but considering these questions can help corporate treasurers frame their company’s risk tolerance:
Components of a typical cash investment policy statement
1. Definition of Portfolio
2. Investment Objective
3. Benchmark
4. Maturity/Duration Guidelines
5. Asset Guidelines
6. Asset Allocation
7. Credit Criterial
8. Other Investment Practices
9. Reinvestment of Income
10. Custodian
11. Accounting Agent
12. Other Vendors
The importance of a well-documented and up-to-date cash investment policy cannot be overstated. The IPS serves as a critical roadmap for companies and the investment managers charged with navigating today’s increasingly complex cash and fixed income markets. By ensuring that all parties understand and observe the same objectives and guidelines, the IPS paves the way for successful administration of the company’s cash. For assistance with your company’s cash IPS or to learn more, contact your BlackRock® representative.
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