InvestmentsJan 16 2013

Cash on the nail is the modern way

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In the past cash was not thought of as an asset class and day-to-day needs were met with cash in the bank or building society and surplus amounts were placed on term deposit. For wealth managers, cash was that part of a portfolio that was temporarily not invested in shares or bonds and so was probably held in their bank account on the client’s behalf. Few people thought that there was any significant capital risk – the only consideration was perhaps to seek the best return and, in an environment where interest rates were much higher than today, that was unlikely to take too much time or effort. The only investors who devoted time to cash were treasurers of banks, insurance companies and possibly the large institutional investors, using wholesale money markets that were largely unknown to the retail investor or, for that matter, most investment managers

Bank failures in the UK were rare and when they did occur, as with Barings, it had little relevance to the retail investor or bank depositor.

However times have changed and cash can no longer be automatically considered risk-free. Countless examples since 2008, coupled with the global economic slowdown, have shown that we cannot now take for granted that all banks are safe. The Financial Services Compensation Scheme guarantees a deposit up to £85,000 but beyond that depositors are at risk and that necessitates either increased research into a bank’s creditworthiness – a difficult task for many – or a spread of cash with more than one bank.

Even this latter approach can be an administrative burden. It is no longer a simple task to open a new bank account and for those with significant amounts of cash it can mean having multiple accounts with £85,000 or less. Given the need to keep monitoring rates available in the banking market, to keep track of the ‘special offers’ and renew deposits, this can become a full-time occupation. Some investors are happy to do this but many do not have the time or inclination.

An alternative place to keep cash is to use liquidity funds. These have been around for many years in the US and have grown in popularity in the UK as a direct result of the falling confidence in banks. These funds provide quick and easy access to a pool of widely diversified money market instruments – formerly the preserve of the large institutional investors. Cash can be deposited and withdrawn on a daily basis and the understanding is that the capital value of units in the funds will remain at par value, with income paid out, usually monthly, or accumulated at the investor’s choice. However capital value and daily liquidity are not guaranteed and ultimately depend on the willingness of a fund’s manager to provide support for their fund in a difficult period in order to retain investor confidence.

This is what happened in 2008 when Lehmans’ collapse caused money markets to freeze for a while and one fund to ‘break the buck’ as the price of some assets fell. It can no longer be assumed that liquidity fund providers will in future step in to protect fund values and liquidity. In the US there are moves to regulate this industry more tightly, given that in 2008 the Federal Reserve was required to guarantee liquidity fund unit holders for a period. The proposed changes would result in a fund’s underlying assets being valued at market value rather than amortised cost, which could lead to reductions in unit prices below par. Daily withdrawals from the funds would be restricted and managers would have to hold a cash reserve.

These moves, even if not carried in full, will ultimately change the nature of such funds and, given that the main providers are from the US, they will also affect funds offered in the UK. In any event these funds will usually offer lower returns than most bank accounts, given that they are obliged to invest in very short-dated assets and deposits and, after fees, returns are now very low. Most of the funds denominated in euros recently had to close to new investors as they could no longer provide a positive return, and some have reopened on the basis that yields may be negative at times. If rates in the UK were to fall further, this could also happen with sterling funds. A typical sterling liquidity fund is now paying a rate of 0.15 per cent to a retail investor and gilt liquidity funds, which offer the highest level of capital protection, are giving a 0 per cent return.

Like all investments, liquidity funds require some research as they are not all the same and, in general terms, those that pay the higher returns are taking more risk in their investment strategy.

So what is an owner of cash to do? Yes, they can use banks and building societies, with discretion and some diversification, and also liquidity funds while they are still giving a positive return, but this may not be the whole answer for someone seeking either a better return or greater capital protection. A solution may lie in using direct investment in short-dated financial instruments and this is where the financial adviser or wealth manager can help. Historically investment managers neglected money markets as not being particularly profitable for them, of little importance in mainstream investment strategies, identifying few opportunities to add value in the past market environment and hence not building expertise in this area.

Some managers will have recognised these changing investment conditions and will have acquired the knowledge and market experience to advise their clients on ways to invest in suitable assets that will complement their traditional cash holdings and enhance yield. However the search for yield should be tempered with caution as it is all too easy to increase returns by moving along the yield curve into longer-dated gilts or corporate bonds. This seems pretty safe while official interest rates stay low but can lead to losses if assets need to be sold before maturity and, let us face it, it is no longer cash and is subject to different market forces.

Similarly it may be tempting to seek higher yields on cash by buying bonds of lower quality, albeit with short maturities, but here again there are risks to capital

If cash is treated as an asset class then it will benefit from the same disciplines as all forms of investment – diversification, research and market knowledge, combined with knowing your client, will contribute to construction of a suitable portfolio.

Of necessity this approach has limitations as many money market instruments trade in large lot sizes and so do not permit construction of well-diversified portfolios with small amounts of cash. For owners of large amounts of cash, a more tailored approach is possible and usually a requirement as not everyone wants the same from their cash.

Martin Nathanson is cash and fixed income portfolio manager at Fleming Family & Partners.

Key points

During the past few years investors and wealth managers have paid increasing attention to cash.

Times have changed and cash can no longer be automatically considered risk-free.

Liquidity funds have been around for many years in the US and have grown in popularity here as a direct result of the falling confidence in banks.