For treasurers, achieving acceptable investment returns is becoming increasingly difficult. Their priority remains to preserve value, but with many institutions currently cash-rich, there is often considerable excess liquidity that needs to achieve optimum performance. With interest rates low, treasurers can no longer simply invest this cash in high-yield deposits or money market instruments.
The range of investment opportunities is greater than ever. While low-risk deposit or money market investments remain the primary destination of treasurers’ funds, there is a growing range of alternatives for excess cash that can be locked away for relatively long periods of time. These include financial instruments such as structured deposits and credit derivatives.
It is now possible for the treasurer to leverage the full capabilities offered by large financial services groups in order to achieve the optimum trade-off between liquidity, risk and return. This takes advantage of the full range of product, credit research, trading and investment management capabilities. But, for this to be successful, an investment strategy should be drawn up that matches the firm’s guidelines or objectives.
Performing in a difficult liquidity environment
The pressure to perform is evident. According to Greenwich Associates, European treasuries earned average annual returns of 3.0 per cent in 2003 and expected to achieve 3.5 per cent in 2004. This was lower than the performances of their Asian peers – 4.1 per cent for 2003 and an expected 4.3 per cent for 2004. It was much greater than those of their US peers – 1.3 per cent in 2003 and 1.4 per cent expected for 2004, respectively. For Europe and Asia at least, this shows that treasurers need to be energetic in pursuit of returns.
But they must also respect fairly tight guidelines. Greenwich reports that 68 per cent of companies in Europe have set investment policies, compared with 49 per cent in Asia and 86 per cent in the US. In other words, investment policies safeguarding risk and liquidity regulate the treasurer’s scope for enhancing returns.
Today’s liquidity environment is demanding. For cash-rich institutions, finding the right investment strategy requires lateral thinking, while implementing it calls for considerable fine-tuning. When deciding how to proceed, institutions need to decide how much risk they are prepared to take, and whether they want to take responsibility for managing the funds themselves. Especially in the light of the more demanding control requirement from regulations, such as Sarbanes-Oxley, the costs for running your own cash portfolio can outweigh the benefits. Therefore, the treasurer might consider subcontracting management to an asset manager within the context of a stated investment policy.
Getting control over your excess cash
Based on cash flow forecasts of the operations and cleared balances on accounts, a treasurer can distillate the total access balances of the firm, which can be invested. Operational balances in one and the same currency can either be automatically and manually concentrated from a variety of group companies to form a single bucket of cleared balances for investment (using cash concentration techniques such as sweeping or notional pooling) or make up a number of smaller balances in different locations.
Armed with accurate and timely balance information, the treasurer is in the position of being able to make the most appropriate decision as to how such surplus funds should be utilised, firstly to reduce total borrowing costs, and then to maximise interest income.
Designing an investment strategy
Designing the investment strategy that best fits a company’s needs is a three-step decision-making process. It involves:
- Balancing liquidity, risk and return;
- Selecting an ‘outsourced’ or ‘do-it-yourself’ investment style;
- Categorising cash into time buckets.
Balancing return, liquidity and risk
In the first instance, the treasurer needs to consider three key factors which need to be balanced and traded off against each other. Which is the desired trade-off between liquidity, risk and return?
Risk:
Or what others describe as security is the risk that the principal amount of the investment may not be recoverable (through counterparty failure or adverse market conditions). Levels of risk may be restricted by lenders. Alternatively, shareholders, rating agency or company objectives issues will influence risk appetites.
Liquidity:
The need to consider how quickly the instrument can be realised for cash if required. The need for liquidity depends on the outcome and quality of cash-flow forecasting and future capex or acquisition plans.
Return:
The need to make an adequate return relative to the current yield. Enhancing the yield will help the treasurer to reduce the company’s cost of capital. Of course, one should realise a higher level of return will be indicative for a correspondingly higher level of risk.
While the emphasis placed on each factor is a matter of risk appetite as determined by a company’s management, a treasurer would usually advise that security is regarded as the primary concern for cash investments, with liquidity and return as secondary and tertiary considerations respectively. An institution’s assets and its ability to meet its ongoing obligations should not be jeopardised for the sake of a marginal improvement in return.
Meanwhile, a variable range of factors will dictate the appetite for risk. In many treasuries, the board or a committee of senior management will have determined the company’s attitude to these investment decision drivers and formulated an investment policy which, for example, sets our acceptable instruments, maturities, currencies and counterparties for short-term investment transactions.
As most treasuries have capital preservation very high on the agenda, most investment policies are very restrictive. The consequence is a lower return on the overall cash position. In order to enhance the return on the cash investment, it is therefore worthwhile to explore the use of different instruments, such as currency and futures in the portfolio.
As a result, all we can conclude is that unconstrained portfolios allow for a more effective and efficient use of risk allocation. The benefits allow the portfolio manager to focus on a smaller number of high quality trades, greater diversification benefits and a broader opportunity set.
Categorising cash into time buckets
Categorising cash into three time buckets – short-term, medium-term and long-term – is an important step in determining the appropriate investment strategy.
- Short-term operational cash designated for daily cash management must be available instantly. Investments must be highly liquid and low risk
- Medium-term cash, which will be available for between one week and three months, could be invested in instruments available at short notice.
- Finally, long-term cash, available for periods of more than three months, can be invested across a wider range of options. This time horizon allows for more volatility, freeing the treasurer to focus on above money market returns. Normally, companies keep this cash to a minimum because investment returns are unlikely to match the cost of capital.
Selecting an ‘outsourced’ or ‘do-it-yourself’ investment strategy
In a world where the efficiency of all areas of companies is keenly scrutinised, treasurers need to make the best possible use of their excess cash. They realise this and are doing so increasingly. But success depends on a well-designed and appropriate investment strategy, which is professionally executed. Especially, when trying to optimise the return of the institution’s cash position, the treasurer will need to take measured risk to increase the probability of generating excess returns.
Within the enhanced cash arena we tend to look at different fixed income ‘alpha’ sources. This is expressed in the form of duration, directional interest rate risk, credit, corporate bonds (investment grade) yield curve shape, country selection and currency. It is important that an enhanced cash portfolio is continuously monitored to ensure that the respective risks are managed dynamically. This monitoring should be executed on a daily basis.
As a consequence, the risk management of enhanced cash products is certainly a complex and demanding process, particularly when viewed within the context and resource base of a treasury department.
Therefore, faced with the management of a large cash surplus, the treasurer needs to select an ‘outsourced’ or ‘do-it-yourself’ investment style depending on factors already discussed, as well as taking into account the cost of running the treasury department in-house. Where the ‘outsourced’ solution would mean that the company asks an asset manager to manage the institution’s cash position. This can be done by the use of money market or enhanced cash funds, or a segregated account. In both cases the investor will benefit from the in-house proprietary risk management system of the asset manager.
For example, a risk management system can construct correlation matrices that look at the correlation of individual assets within a portfolio and the effect of groups of assets upon each other under various scenarios. This helps us to construct portfolios with a greater number of uncorrelated types of ‘alpha’ and a higher level of diversification.
In the case of a ‘do-it-yourself’ approach, ABN AMRO’s liquidity advisory desk designs a strategy that it believes best represents the company’s goals. The institution can then choose which parts of the strategy to adopt. This has the advantage of greater flexibility and control, albeit at the expense of running a full investment team. In some cases, the company may decide a combination of the two best fits its needs.
This information is provided to you for information purposes only. Before investing in any product of ABN AMRO Asset Management (Netherlands) B.V., you should inform yourself about various consequences that you may encounter under the laws of your country. ABN AMRO Asset Management (Netherlands) B.V. has taken all reasonable care to ensure that the information contained in this document is correct but does not accept liability for any misprints. ABN AMRO Asset Management (Netherlands) B.V. reserves the right to make amendments to this information. ABN AMRO Asset management (Netherlands) B.V. is registered with the Dutch regulator (Autoriteit Financiële Markten)
CUSTOMISING EXACT SOLUTIONS
When formulating liquidity investment strategies, every institution needs exact solutions. It goes without saying that the required trade-off between liquidity, risk and return is highly individual. But the company may have other considerations related to, for example, tax or regulation.
ABN AMRO’s liquidity advisory desks draw on the full range of capabilities from commercial banking, asset management and treasury/financial markets to create solutions that are finely tuned to individual situations.
The advisory desks design their solutions from a portfolio approach, looking at cash as a number of buckets with different time horizon. Each bucket will require a different instrument, resulting in a mix of investment products. In this way the corporate is enabled to enhance his return on his total cash position.
Once a strategy has been agreed, it will be executed on an ongoing basis. If the company has chosen the full service, ABN AMRO Asset Management will execute it and report back. If the active service has been selected, the client will implement this through either the liquidity advisory desk, or directly through the bank’s dealers.
Figure 1 Balancing Risk, Liquidity and Return
FREE UP YOUR INVESTMENT GUIDELINES
In the present investment environment of low credit spreads and low variations between domestic bond markets, current guideline tools of credit and country selection have proven to be less effective for creating value. Therefore, ABN AMRO Asset Management has introduced a concept to provide domestic bond investors with a ‘portable alpha’ approach where the investor has the risk profile equal to the traditional mandate but excess returns are enhanced by increasing exposure to the broader fixed income markets.
High quality alpha opportunities are often not captured within traditional domestic bond mandates. Why is this?
- Domestic portfolio managers often use duration as a blunt instrument. Specific views on the two-year segment of the yield curve can often only be implemented in the five-year segment, even the two segments can be driven by different forces.
- Yield curve opportunities are often only partially exploited. When two different opportunities are identified at the same segment of the yield curve, often only one can be implemented, leaving the potential excess returns untapped.
- The asymmetric use of overseas bond and currency markets reduces the opportunity set and increases the volatility of returns relative to the benchmark.
- The ability to add alpha in the corporate bond market is mainly confined to top-down and sector allocation rather than a range of high quality bottom-up opportunities.
