Short-term Investment Strategies for Treasurers

Publication: gtnews.com


Short-term investments made by treasurers have come under a great deal of scrutiny over the past year, as many previously sound instruments have under-performed or collapsed. Which investment instruments should treasurers be considering, and what value should be placed on security, liquidity and yield in an overall investment strategy? 


The sub-prime mortgage crisis in the US and the ensuing liquidity crisis have had a profound effect on short-term investment options for treasurers around the world. CFOs, CEOs and boards are scrutinising treasury departments closely to see which investment instruments have been selected. Treasurers in turn have been in closer contact with their asset managers and banking partners to understand what is happening in the financial markets and how this is affecting their own liquidity. In this period of uncertainty, what strategies should treasurers be employing in order to achieve security of investment, maintain liquidity and create yield? 


A good start would actually be to keep in regular contact with your fund manager. The liquidity crisis may have meant that you put names and voices to the people helping to manage your cash investments for the first time, by building on these relationships, treasurers can learn much more about the instruments that their cash is invested in. 


The Investment Strategy Risk Conundrum for Treasurers 


Due to the market problems of the past year, it is understandable that security and liquidity are the main qualities that treasurers look for in a short-term investment instrument. But what about yield? Different fund types and investment instruments were falling over themselves to offer investors the best yield ratios up until a year ago, but is this still important? Well, it should be, but it is important that treasurers understand how the yield projections they are being shown have been put together and, as always, if something looks too good to be true then it probably is. This is a theme picked up by Mark Rimmer, from BlackRock, in the Guide to Money Market Funds - Part 1: The Current Landscape, which discusses key issues to keep in mind when choosing a cash manager. "The underlying investment dynamics of a top-yielding fund might be based on some unattractive investments from a long-term perspective and this is the type of investment information that you should ask your fund manager for," says Rimmer. Once again, it is clear that developing a good relationship with your fund manager is vital, as this can help avoid any nasty surprises further down the line. 


The balance between security, liquidity and yield that treasurers face when making short-term investments is something that François Masquelier, honourary chairman of the European Association of Corporate Treasurers (EACT) tackles in his article, Post Sub-prime: The Impact on Treasurers Managing Liquidity. All investments should ideally bring a return in terms of yield, but in the current climate this can be easier said than done, as treasurers need to also ensure that their investment strategy diversifies risk, remains liquid and also favours the corporate's main bank relationships. Remaining liquid can represent a cost in terms of failure to earn interest, and Masquelier identifies the fact that corporate strategies and objectives are not always aligned in this regard, something that can have a serious effect on a company's bottom line. "It's a subject that CFO's may have neglected too often in Europe. Last summer's events reminded everybody that this market could present considerable risks because of a lack of visibility on certain funds that qualified as dynamic, or even because fund managers were frantically searching for a higher return," says Masquelier. Higher returns, by their very nature, have a higher underlying risk profile, so it is vital to remember this when looking at short-term instruments to invest in. 


Even basic bank deposits are exposed to significant risk, as Alain Kerneis, from Goldman Sachs Asset Management, discusses in his article, Managing Corporate Cash Reserves During Turbulent Times. Corporates with large allocations in bank deposits are exposed to significant counterparty risk since the market in the UK and US significantly re-priced the risk of default from financial institutions. "Although a survey published in 2006 showed that European non-financial corporations held on average 60% of their reserves in bank deposits, we believe that the recent market events will prompt many corporations to limit their allocation towards bank deposits," says Kerneis. He also expects treasurers to spread their bank deposits across a larger number of counterparties or diversify across other low risk asset classes such as short-dated government bonds. 


A corporate's risk management policies are tightly linked into its short-term investment strategy, more so today than ever before. David Rothon, from Northern Trust, looks at the risk aspect of MMFs in his article, Cash Management Perspectives on Short-term Investments. He makes the point that enhanced and short bond funds can be just as appropriate for investors as MMFs, providing that their appetite for risk and the objectives of their funds' strategy are in line with one another. "As this process of risk reappraisal evolves, investment strategies in the short duration space will become more clearly defined, enabling investors to better manage their risk budget," says Rothon. A broader, better-defined product array will give investors the confidence and conviction to tactically manage their cash going forward. 


Regulations Helping Growth of MMFs in Europe 


In Europe, the MMF market has lagged behind the US in terms of assets under management, but recently it has been catching up quickly. A major reason for this has been a shift in the regulatory landscape. Changes to the Basel II capital adequacy framework and the introduction of the European Union's Markets in Financial Instruments Directive (MiFID) has made investing in MMFs an attractive prospect for banks. Under the original Basel Accord, financial institutions were required to make large provisions against these investments. MMFs were also treated the same as higher risk equity funds, making them relatively expensive for banks to hold. However, this has now changed, as Kevin Thompson, from Fidelity International, discusses in his article, Money Market Funds Weather the Credit Storm. With the new framework, the risk weighting of MMFs has been reduced to 20% from the earlier 100%. Banks are also required to hold far less capital in highly rated MMFs, which makes these instruments an attractive option for short-term cash placements by banks. 


"Additionally, under MiFID, banks will be allowed to invest client money into AAA-rated funds, earning a higher return than just relying on bank deposits," explains Thompson. "With these structural and regulatory changes coming into place, we expect the market in Europe to grow significantly over the coming years." As cash from banks floods into the MMFs, this adds to the security of the market from the perspective of the corporate treasurer. 


Need For a Better Definition of MMFs 


The downturn or even collapse of some short-term investment markets has lead to many calls within the industry for a better definition of what an MMF actually is. As EACT's Masquelier says, it is important not to confuse treasury-style MMFs with similar looking products that actually have a greater risk profile. "It is unfair and even dangerous to claim that the risk would be the same when the duration of underlying investments is longer (greater than three months) and that the return on investments is clearly greater than the reference indexes (e.g. EONIA, EURIBOR, LIBOR)," explains Masquelier. 


"With an AAA-rated stable net asset value (NAV) MMF, corporate treasurers can be confident in the knowledge that they have access to their money on a T+0 basis and they are able to maintain this flexibility,"says BlackRock's Rimmer. This type of MMF, often referred to as a 'treasury-style' MMF, has been a success story of the past 12 months, as treasurers have been attracted by the relative security and liquidity they offer as opposed to enhanced cash funds or bank deposits, for example. 


The credit crisis has created an inflection point in the MMF industry regarding how investors view MMFs, perhaps permanently. Karen Dunn Kelley, from Invesco, describes in her article, Money Market Funds Evolving from Market Turmoil, that since last summer, her company's cash management team has conducted hundreds of meetings with investors who have been surprised by the impact of the credit market crisis and now have a heightened awareness of the risks in their MMF investments. 


Trade organisations agree with the IMMFA in calling for clarity of definition for MMFs in order to avoid previous errors of judgement regarding the underlying asset risk of different short-term investment instruments. François Masquelier says that the EACT, like many national treasurer associations, thinks that distinguishing a treasury-style MMF from other cash funds such as enhanced, cash-plus or dynamic MMFs is crucial. "Turning to 'pure' monetary funds with an AAA rating (IMMFA funds) has shown during the crisis that it was possible to guarantee liquidity while offering a solid return greater than the EONIA index (for euro funds)," he explains. 


This clearer definition is beginning to take shape, as Kathleen Hughes, from J.P. Morgan Asset Management, highlights in her article, Short-term Investors Get Smart. She refers to how the treasury-style MMFs have also been defined as qualified money market funds (QMMFs) by IMMFA. QMMFs are the most conservative of the broader MMFs category, which is widely used in Europe to describe everything from stable NAV funds to enhanced yield funds, short-term bond funds and even total return style funds. "The differentiating factor between all of these types of fund has always been liquidity," says Hughes. "QMMFs are buy-and-hold strategies that invest solely in securities maturing in the near-term. Therefore they do not normally rely on the presence of market participants to buy securities from them in order to meet the liquidity demands of their shareholders." 


This undivided attention on very short-maturity instruments is a big distinction between QMMFs and other MMFs with higher risk profiles. Some longer-term enhanced, dynamic or total return funds implement active strategies that can buy securities maturing as far out as 30 years, which means they have been at the behest of market liquidity when it comes to meeting shareholder redemptions. J.P. Morgan's Hughes notes: "Such strategies worked perfectly well until market liquidity vanished in the summer of 2007, forcing the fund's to sell securities at discounted prices." These losses were then passed onto investors, which is the last thing treasurers want. 


Which Funds to Choose? 


Treasurers have started to differentiate between the MMFs that are available to invest in, and the asset managers that are offering the product, with risk factors now being a key factor in fund selection. The size of the fund, its portfolio holdings and the strength of the provider are increasingly under scrutiny. This is something that J.P. Morgan's Hughes points out in her article. "The size of the fund, in particular, directly addresses large investors' fears of being a big fish in a small pond. If you make up too much of the fund, how confident are you that adequate liquidity will be provided?" she says. 


The financial strength of the provider is now also a consideration when looking at which short-term instruments to invest in. While mutual fund investments are 'ring-fenced' in terms of the fund provider's balance sheet, the funds themselves are not guaranteed by the asset management company, or the parent bank entity, if one exists. Despite this, many investors believe that if the stable NAV of an AAA-rated fund is in jeopardy, the provider will act to prevent any losses being passed onto shareholders. If this assumption is correct, the provider can only do this if their balance sheet allows it - which is why there is a focus on the financial strength of the provider. This is even the case when investors look at treasury-style MMFs. As J.P. Morgan's Hughes states: "These changes have been profound and are likely to be permanent." 


Taking Advantage of Technology 


While treasurers can benefit greatly from an active working relationship with their fund managers, technology can also help when it comes to investment decisions. This is a topic that Basak Toprak, from Citi, highlights in What Now? What Next? - Part 3: Harnessing Technology to Simplify Investment Decisions. Investment portal technology is one such advance, which allows corporates to access information about all of their investments online through one channel. "The convenience of seeing all of their investments on one screen with the ability to compare them in terms of their assets under management, ratings, yield and average maturity is a significant advantage," says Toprak. MMF portals are provided by both banks and independent operators and, at a time when transparency of products and investment is critical, portals can provide visibility, mobilisation and optimisation of corporate cash. 


In his article, Investing Through the Liquidity Crisis, Kirk D. Black, from the Bank of New York Mellon, shows a practical example of how an MMF portal can benefit the investor. The US Federal Reserve recently reduced its funds target rate significantly in an attempt to ease the liquidity crisis. This has helped MMFs to outperform most short-term issuers of commercial paper and other corporate discount notes and government securities. As a result of this, many investors are moving their portfolios from individual security issuers into heavier concentrations of MMFs. "An investment portal allows the investor to efficiently purchase a market of MMFs, taking advantage of their current out-performance. Should the Fed pause easing for an extended period or reverse course into a tightening posture, portal users can redeem their MMF positions and re-enter securities markets on the portal, purchasing instruments such as commercial paper and other discount notes," explains Black. Keeping ahead of the market curve is important, especially in the current turbulent climate, and managing your short-term investments through one of the many available portals can be a helpful. 


Significantly, Citi's Toprak points out that "while adoption of portal technology grows in the transaction space, they do not replace existing relationships with fund managers or the need to have someone at the end of the phone to answer questions on the investment offering or provide feedback on market developments." 


Conclusion 


As the market turbulence of the past 12 months has dealt blows to competing short-term investment instruments, the security and liquidity that treasury-style MMFs afford has seen their popularity rapidly increase, particularly in Europe. Going forward, it is important that investors do not revert to a laissez-faire approach to short-term investments - security and liquidity are the vital components at the moment, but to neglect yield could cost corporates in the longer-term. It is important for treasurers to arm themselves with as much knowledge of the market as possible, which can be achieved by having a good relationship with fund managers, as well as utilising any technology that can simplify and enhance investment decisions, such as MMF portals. The funds industry itself needs to ensure that it is catering for investors by providing accurate and up-to-date information on the investment instruments it offers, and that these are clearly defined with transparent risk profiles. The growth of treasury-style MMFs has shown that, even in tough economic times, there are good short-term investment opportunities out there and, if the industry learns from previous mistakes, these can grow. For example, at a recent conference looking at MMFs, Donald Aiken, the chairman of the IMMFA, said that he would not rule out the return of enhanced cash funds given time, albeit in a slightly different format. By keeping up with industry developments such as these, treasurers can be in a position to take advantage of future market alterations and add value to their company by doing so.

The Status of Money Market Funds in 2007

Publication: gtnews.com

Money market funds (MMFs) have been popular short-term investment instruments in the US for over 30 years, and are now going from strength to strength in other regions such as Europe and Asia. This commentary looks at the different types of MMFs available, what is influencing their global performance, and what new developments may help sustain their growth.

Variation in MMFs

As an investment instrument, there are three key areas that MMFs offer a return on: security of investment, liquidity, and yield. As treasury might, at any one time, place a higher value on one of these features, there are different varieties of MMFs to cater for different corporate needs. In his article, Different MMFs for Alternative Treasury Goals, Andy Kelly from Fidelity offers definitions of three different types of MMF. Kelly says: "At one end of the spectrum are liquidity funds, which invest exclusively in high credit quality and liquid investments. This type of fund has a typical weighted average maturity of 60 days or less, and provides daily liquidity as well as a stable net asset value (NAV)." Further along this spectrum are 'cash-plus' funds, which invest in more illiquid instruments of slightly lesser credit quality, extend portfolio maturity further out onto the yield curve, or sacrifice same-day liquidity to aim to produce higher returns. Cash-plus funds are more suited for capital that a corporate may wish to invest on a six to 12 month timeline. And finally, at the far end of the MMF timeline, are enhanced cash funds. These invest a portion of their assets in riskier, more volatile or less-liquid assets, such as asset- or mortgagebacked securities, or apply less stringent restrictions on the credit quality of their investments in order to boost returns. The main focus of enhanced cash funds is to generate maximum yield, and is suited for corporate treasurers with a longer-term investment of at least one year minimum.

In her article, Liquidity Funds Hit Their Stride, Kathleen Hughes from J.P. Morgan Asset Management examines the benefits of liquidity funds, particularly when compared with investing the same cash into a regular bank account. According to Hughes, liquidity funds differ to bank deposits in that the risk to money invested is spread across dozens of different securities. She says: "Credit is diversified and volatility reduced through a broad portfolio mix, with a maximum of 5% of the fund placed with any one issuer and diversified across industries." Furthermore, the securities in which liquidity funds are invested can help many funds obtain a triple-A rating from Moody's, Standard & Poor's and Fitch. This contrasts with banks, whose own ratings are typically double-A or worse. 

Cashing In 

Clearly, as a short-term investment instrument, MMFs have a lot to offer corporate treasury. In her article, MMF Portals - Becoming a Reality in the European Market, Kate Baldridge, of Institutional Cash Distributors (ICD), notes that MMFs in the US hit an all time high in May 2007, with assets of around US$2.5 trillion. 

But this record-breaking success cannot simply be down to the choice and innovation of product offerings available, the continued growth of MMFs also reflects what is happening in the market as a whole. Peter Knight of HSBC draws attention to this in his article, Five Effective Principles For Global Cash Management, noting: "Over the past decade, the amount of cash held by S&P500 companies has risen from US$100bn to US$600bn. The result of a prolonged global economic boom and a growing tendency to retain cash rather than make expensive acquisitions, this trend means that corporate cash is now equivalent to about 7% of the S&P500's total market capitalisation." With such vast amounts of cash available, it is understandable that treasurers are investing in a variety of MMF products. This was clearly a factor in May's US record high, and is also being seen in other global markets. 

The continued growth of MMFs in the US has come at a time when some aspects of the economy would not necessarily seem to encourage it. George Hagerman of CacheMatrix identifies two of these market trends that MMFs have bucked in his article, Converging Factors Boost US Institutional MMFs. Hagerman says: "The first factor is the relative strength of the US stock market. In general, a rising stock market typically means that cash positions fall as investors put more money into equities markets. Yet with major market indicies moving generally upward over the past few years… MMFs have also continued to rise." Hagerman also draws attention to the growth of aggressive company stock buy-back programmes, and how MMF take-up has still grown despite this. 

Regional Trends 

MMFs have increased in popularity in Europe throughout the past decade. In his article, The Current State and Future Potential of European Offshore MMFs, Justin Rose of Standard Life Investments explains that: "European offshore MMFs under management grew rapidly from US$70bn in 2000 to US$496bn. The key growth factors were a combination of corporates building up unprecedented cash reserves… and a relatively stable, historically low interest rate environment." 

However, even despite this large and quick growth in Europe, Fidelity's Kelly points out that, "MMFs still only represent 4% of European broad money supply (M3) compared to 25% of M3 in the US." Clearly there is still vast potential growth left in the European MMF market, and Kelly mentions that some analysts believe in the next five years MMF assets under management in Europe could hit US$1 trillion. This would still appear to leave the US as the major home for MMFs, looking at the record total of assets under management previously mentioned. 

With regards to liquidity funds, Hughes, from JPMorgan Asset Management, describes how the European market for these has been increasing roughly 50% yearly. Hughes suggests that: "Increasing merger and acquisition activity [is a] potential driver behind the surge in European demand for very liquid strategies. Demand in recent years has also lead to the creation of many other markets, particularly in Asia and South America, with the development of local currency liquidity funds." As the market for MMFs continues to grow at high rates in the US and Europe, it does seem to be a natural consequence that they will take hold in more emerging economies also, provided the infrastructure to support the market exists. One cautionary note on this topic is provided by HSBC's Knight, who warns that: "Processes and systems in Asia remain highly fragmented - particularly given the high levels of foreign exchange control in markets such as China and India." 

Regulatory Support 

Regulations that govern MMF structures have always been important in supporting the growth of these investment instruments - something that has been seen historically and is still seen today. Standard Life Investment's Rose notes that Rule 2a-7 in the 1940 Investment Company Act was crucial for the growth of MMF market, providing it with a regulatory structure. In contrast, the European MMF market has been lacking an equivalent to the Rule 2a-7. But, in recent years, some European legislation has contained elements that should have a positive knock-on effect on MMFs. But Rose notes: "To date, the sizeable new investment flows expected from regulatory changes, such as the risk weighting changes under the Basel II-inspired Capital Requirements Directive (CRD), have yet to materialise. Although Basel II came into effect on 1 January 2007, its implementation needs to be viewed as a process, as the regulators allow financial institutions to gradually release capital. For example a 100% capital floor for the Internal Ratings Based (IRB) Advanced Approach does not come into effect until 2010." 

So regulatory progress in Europe may be somewhat slower than appearances suggest. However, Fidelity's Kelly emphasises a positive development: "As a consequence of the CRD, many MMFs having a triple-A rating are being put in line with bank deposits in terms of regulatory treatment. Furthermore, from November 2007, custodians holding client money will be able to place it in certain MMFs under the Markets in Financial Instruments Directive (MiFID), rather than being restricted to bank deposits." Regulatory support such as this is key to the European MMF market reaching a similar level of maturity as its US counterpart. 

And there is some positive news from Standard Life Investment's Rose as well: "The Undertakings for Collective Investment in Transferable Securities (UCITS) Directive now accommodates MMFs and legitimises the use of amortised accounting. This has been a step towards the goal of an integrated market and, if European regulators can remove the administrative and regulatory frictions that slow down cross-border market access, a functioning pan-European integrated market may yet be achievable." 

Delivering MMF Performance 

As with every area in modern cash management, MMFs should provide the best returns as efficiently as possible for the treasurer or investor. This means automation, and the most popular form of automation in the MMF marketplace is to use an Internet-based platform 'portal'. As Standard Life Investments' Rose explains: "MMF portals have become an important part of the European MMF industry as they clearly offer the right service for some clients." Rose continues: "Portals will continue in importance as institutional investors are likely to be more performance driven than retail investors and they will utilise portals as they demand speed of execution, transparency, larger size tickets, lower transaction costs, later cut-off times and straight-through processing (STP)." 

In terms of the future for MMF portals, ICD's Baldridge identifies three key developments for this technology - the development of a comprehensive cross-market trading platform that can offer STP, the addition of confirmation matching to MMF portals, and the ability to offer a selection of different enhanced funds. She suggests that these additions would help to create a "complete short term liquidity tool." 

Conclusion 

The global MMF industry is in good health, with record levels in the US, European take-up rapidly advancing and new funds emerging in regions such as Asia and South America. The regulatory environment is making MMFs more appealing to investors that would previously have used bank deposits but are now encouraged to take advantage of the variety of MMFs available, depending on their investment requirements. 

But does the growth in the MMF market necessarily indicate that it is the best place for cash rich companies to invest? Of course not, but when considered in the context of an overall cash management policy MMFs do have a lot of attractive elements. Corporate treasurers need to ensure they have a well thought out and responsive cash management policy - something that HSBC's Knight covers, by setting out his five principles of global cash management. These are: 1) manage cashflows effectively; 2) forecast cashflows accurately; 3) tranche cashflows intelligently; 4) establish an appropriate investment policy, and; 5) implement effective investment management. These are core strategies that, if given enough attention by corporate treasury, should ensure that maximum value is taken from all cash management activities, including MMFs.