Over the past 10 years, treasurers and other cash investors have come to accept AAAm rated liquidity funds as an attractive alternative to short-term deposits. These funds offer investors the benefits of security, liquidity, competitive returns and operational simplicity. The first European liquidity funds were launched in the mid-1990s and were developed in line with the successful US liquidity funds. At the end of June 2006, there were 26 fund providers with total assets under management of over £150bn (€222.1bn). Fund managers are now starting to offer enhanced cash funds alongside their standard liquidity funds as an investment for longer term cash.
Liquidity funds are structured as open-ended investment companies (OEICs), and are generally listed in Dublin or Luxembourg. They invest in a diversified range of highly-rated money market securities, including short-term deposits, commercial paper, certificates of deposit and floating rate notes. They have a maximum weighted average maturity of 60 days and typically have a target return of seven-day Libid. They are generally rated AAAm (or equivalent). They are designed to look like a bank deposit with a constant net asset value (NAV) and a dividend which can be paid monthly (like interest) or reinvested in the fund. This is achieved by using amortised cost accounting which is allowed because of the funds’ short duration.
Perfect combination
The combination of same day access, competitive returns, AAA credit rating and straight forward operation has resulted in liquidity funds becoming an accepted home for short-term cash.
While liquidity funds can provide an attractive alternative to bank deposits for short-term cash they do not always offer a good match for all of a cash investor’s requirements. Many treasurers are managing cash to a three to six-month benchmark and have cash which is effectively long-term and will be sitting on the balance sheet for the foreseeable future. They would like to achieve higher returns (over the medium term) from this cash, while still keeping a focus on the preservation of capital and liquidity. These requirements have traditionally been met by treasurers investing directly in money market securities and term deposits. This approach has the disadvantage of being relatively illiquid (as cash is tied up in term deposits) and potentially costly if cash is needed unexpectedly at short notice. Asset managers have been developing enhanced cash funds, which aim to be a better fit for the investor’s requirements for longer term cash.
Enhanced cash funds are not constrained by the requirements of an AAAm rating and therefore asset managers are in a position to offer a much wider range of products. Some funds seek to enhance returns by taking greater credit risk or investing in structured products, others focus on seeking returns from increased exposure to the yield curve. The asset manager may also choose a longer benchmark, for example three-month Libid. Alternatively the benchmark may still be seven-day Libid but with an outperformance target. The funds will usually have a notice period of up to one week for redemptions and possibly for subscriptions.
This greater freedom for the manager means that investors needs to look closely at the different funds and managers to ensure that they are both comfortable with the proposed strategy and that they are confident that the fund manager has the expertise to carry it out successfully. The investor also needs to consider the size of the fund, how liquid it is and the number and diversification of the investor base. The selection process will therefore be similar to the process used for fixed income managers.
Key differences
One of the key differences between liquidity funds and enhanced cash funds is that liquidity funds have a constant NAV and are valued on an amortised cost basis. Most enhanced cash funds have to be marked to market daily (because of their longer weighted average maturity). This, combined with their longer duration and potentially greater exposure to credit, results in a greater volatility in returns both daily and over longer periods. This may cause problems for a treasurer if he is tracking returns against a benchmark on a daily or even monthly basis. Adverse market conditions may also cause an enhanced cash fund to underperform a liquidity fund in the short term.
Despite these potential drawbacks enhanced cash funds offer some major benefits. These include:
- The ability to benefit from longer duration while still maintaining liquidity;
- The opportunity to benefit from investment manager expertise
- The economies of scale which come from being part of a pooled fund.
In association with Insight Investment.
Insight Investment was launched as the asset management business of the HBOS Group (formerly Halifax and Bank of Scotland Group of companies) in September 2002; and is already one of the UK's largest investment managers with £96.6bn in assets under management as at 30 June 2006. At Insight we are committed to developing investment management services that offer clients precise solutions to their financial needs and have built expert teams covering the full range of asset types - equities, bonds, absolute return and private equity. In 2003 we restructured our entire investment platform to provide clients with access to a new and broader range of financial solutions. These include liability driven investment strategies, structured solutions, absolute return products and a new and innovative range of cash management solutions.
