Increased demand from institutional investors for an alternative to traditional bank deposits has resulted in huge growth in money market or liquidity funds.
These vehicles offer investors a flexible and secure way of managing the cash portion of their portfolios.
“Corporate treasurers and others are looking for more sophisticated products beyond the traditional bank deposits,” says Kathleen Hughes, head of the EMEA sales team of the global cash business at JPMorgan Asset Management. She explains that as different markets mature, AAA-rated funds are becoming more and more popular among investors attracted by their daily liquidity, high credit quality and security.
During the first nine months of 2006, some $49bn (€39bn) went into AAA-rated liquidity funds, compared to the $35bn registered during the same period last year. Changes in regulations and the increased visibility of these products, mean similar levels of growth should be sustainable over the short to medium term. Although in absolute terms the US will continue to be the largest market, Europe presents very attractive opportunities in growth terms.
“The US market is much more mature so growth levels are slower,” Ms Hughes explains. “Europe is moving from a small base and has a higher growth rate. Of course [this rate] is not sustainable forever, but in Europe there are some $2500bn of assets still sitting in traditional bank deposits,” she adds.
The growth of assets in liquidity funds is taking place at the same time as corporate treasurers and other investors are becoming more professional.
 | “I think this is due to the increasing importance of cash on balance sheets,” says Peter Knight, global head of liquidity at HSBC Investments. “It is no longer there just to pay the bills. It is an investment to be managed.” |
This increased professionalism is resulting in what Mr Knight calls “tranching of money”. In other words, corporates are now looking at their money and realising they need some of that capital to keep the business going. But they also see they have some cash that they may or may not use in the future, depending on whether they are going to be paying dividends, buying stock back or acquiring a company. “And that money can be invested to get higher returns,” Mr Knight says.
He explains that in many cases, treasurers still choose bank deposits. “But there is a whole bunch of issues here. Firstly, it is not the best thing to do, but also banks don’t want to balloon their balance sheets with deposits they’ve got no need for.” Therefore, banks tend to be more selective about the money they take on board and, as a consequence, they also try to encourage clients to use non-balance sheet vehicles. “Vehicles like money market funds fit in very nicely.”
Greater understanding of money market products and liquidity funds in general is resulting in more investors taking a step further into enhanced cash funds. Although it is difficult to find a standard, industry-wide definition of these products, in broad terms these are actively managed portfolios that aim to generate higher total returns. Whereas money market funds have a duration of up to three months, enhanced cash has a longer investment horizon and typically requires at least 12 months to generate benefits that justify the additional risk.
At JPMorgan, Ms Hughes says that, compared to the AAA-rated world, the development of the enhanced cash market is more difficult to measure. “The enhanced market is not easily defined, so it is hard to obtain figures about its growth.” She says that during the first nine months of the year, the firm’s enhanced cash business grew by around 40 per cent. “So we can see [enhanced cash funds] becoming a more important part of cash portfolios where clients will combine a AAA-rated fund, for their very liquid cash, with an enhanced fund, for something that has a longer investment horizon.”
She adds that the appetite for these funds differs across countries and types of investors. “France is a country where there seems to be more appetite for taking a bit more risk in cash funds and they have a very large market of non-rated funds that go beyond the typical cash fund.”
Mr Knight comments that the demand for enhanced cash is related to a better understanding of risk among global treasurers. “The important think to remember when taking a step up the ladder is what risk are you taking.” He explains that, when designing products, they try to understand what the client wants. “We are not going to design things that firstly are not allowed by their investment policy, and secondly don’t give an optimal return.”
In order to find the right product, the clients have to define the minimum credit rating they are comfortable with, the maximum duration they are prepared to have in their portfolio and what sort of liquidity they want to keep in case they need the money. These three factors are part of the same equation, and the provider needs to come up with the answer or, in other words, the yield. Mr Knight explains that in many cases treasurers come to providers asking for enhanced yield, but first they have to go through those three questions to see if this type of strategy is suitable for their portfolios.
“We’ll come to you and say ‘as a treasurer, how much capital risk are you prepared to take? Are you prepared to have a loss in any one quarter or in any one year’. If the answer is no, that would restrict the amount of credit risk and duration risk we take,” he explains. “We would like treasurers not to look at the answer, but actually to look inside the box a little bit. As soon as you step up the risk curve, it is important that both suppliers and buyers get together to make sure they are talking the same language because unfortunately sometimes they don’t.”
Having said that, Mr Knight says that enhanced cash is a growing area. For instance, following the interest rates record lows after 9/11, American corporations – acutely aware of the loss of income – started asking for products with higher yields than those offered by cash funds under the SEC’s rule 2a7, which governs the management of stable net asset value money market funds.
“This [rule], unfortunately, puts you in a very tight straightjacket. It is important because it recognises all the risks that can happen in a fund and stops them. But to enhance deals you have to step outside those funds and what you see in America is an increase in the non-2a7 type of funds,” Mr Knight comments.
He says that the appetite for enhanced cash is significant in markets like France and Germany. “Also in the Far East there is a risk appetite for enhanced return, but also for security.”
Mr Knight explains that those considering the use of enhanced products have to be careful when it comes to choosing the right vehicle. As an analogy, he uses the example of a radio with two dials, one representing credit and the other duration. “Money market funds twiddle with those two dials, and they can do this up to certain point – less than a year when it comes to duration and A1/P1 rating when it comes to credit,” he explains. If they go beyond that, they cause “too much noise and you can’t hear the music. So what you do is add more dials, different investment styles”. Just like in equity investments, more diversification can reduce risk. “But you have to be careful with this. If you start putting derivatives, foreign exchange contracts, is that allowable within your investment policy?”
Enhanced strategies are increasingly being used within overlay strategies, collateral management and liability driven investment (LDI). The latter is particularly interesting, as changing funding requirements are forcing pension funds to implement LDI strategies within their portfolios. According to a recent report by Northern Trust Global Investments, pension funds searching for a LDI solution could benefit from the cost efficiency of enhanced cash strategies, the fact that they are easy to understand, require less governance and might result in less volatility on the sponsor’s balance sheet.
Although some would prefer to choose a traditional liquidity products as opposed to an enhanced strategy, what is clear is that the growth of the LDI segment will impact on the future development of cash management products.
“Pension fund managers are now becoming more focused on this type of investments. A lot of times LDI products have, at their core, a cash element that can be a AAA or AA-rated money market fund or an enhanced cash fund.” says Ms Hughes. “We also see pension funds and some pension fund consultants beginning to look at cash as a separate asset class. I think those are two developments that would benefit the growth of liquidity funds in Europe.”
At HSBC, Mr Knight mentions that the soon to be introduced Capital Requirements Directive under Basel II will also have a “significant impact on how financial institutions invest their money and money market funds will be the beneficiaries of that”.
