John Cummins assesses the current trends in liquidity management in the UK fund management market and suggests some alternatives to manage liquid portfolios and yields in a measured risk environment
Liquidity or cash management has raised its profile within the fund management industry in the last few years. This has been driven by a variety of factors, including the need for increased performance on all assets, the increased universe of cash investments such as derivative instruments and continued innovation within the financial markets.
The object of this article is to assess the current trends in liquidity management in the UK fund management market, highlight the conflicting desires for yield, security and liquidity and suggesting some alternatives to manage liquid portfolios and yields in a measured risk environment. Once the risk parameters have been established and the risk appetite satisfied, then a liquid portfolio can be built to meet these risk appetites.
The growth of the range of cash-like instruments for liquidity has continued apace with the development of the segregated cash fund industry and the AAA liquidity funds market. These have been a great success in the US where over $2 trillion is managed within the AAA funds industry.
They are also enjoying rapid growth in Europe ' the amount invested in these vehicles is over 70 billion euros.
As well as US fund management companies entering the market, the established players such as Merrill Lynch Asset Management and Standard Life are also providing services.
The desire for effective cash management has been driven by investor trends, which place a premium on risk assessment, liquidity and yield.
The consolidation within the global financial services market has seen a decline in the number of AA-rated counterparties that are active in short dated cash markets.
There has also been an emphasis on balance sheet efficiency and return on equity from bank's senior management so that liquidity and banks' desire to make markets in many of the on balance instruments has been reduced.
The decline in highly rated counterparties has been matched by investors' increasing need for quality risk and counterparty assessment.
This places increasing emphasis on the credit ratings agency activities and how the credit methodologies are incorporated into a Treasury function.
Fund managers often have specific credit ratings criteria, which increases the importance of a rigorous and robust credit risk methodology.
These ratings can be subject to rapid changes and the relationships between spreads and ratings have to be monitored constantly to track anomalies and gain early warnings on selected credits. Any sharp divergences and unusual credit spread activity such as widening commercial paper spreads in short maturities are important market indicators.
For example, the Russian default problems highlighted the usefulness of market price information in conjunction with credit ratings. Liquidity management is as much taking notice of events in the debt market as it is relying on ratings from the recognised ratings agencies.
Liquidity managers have an ongoing requirement for instruments, which have ready sources of liquidity or ability to readily realise their investments. The more complex instruments that the portfolio manager uses, the less liquidity there may be in those markets.
The choice of instruments for short-term investors is wide- ranging, from simple cash deposits to certificates of deposits, short-term gilts, sterling, euro and US dollar commercial paper, floating rate notes, swaps and option-linked investments.
There have been continued innovations to these instruments such as Sonias (Sterling Overnight Inter-bank Average Index), total return swaps and asset- backed paper, which may have unique and non-standard cash flow characteristics.
It is important to have the accounting systems, pricing and valuation software and experienced people to undertake these activities. The correct administration and accounting of all of these new or old Treasury instruments is critical in running a controlled and secure liquidity management operation.
The search for yield must be tempered by the desire for liquidity. This trade off can be a matter of judgement and is based on the risk appetites and overall liquidity needs of the customer of corporate requirement. If core liquidity is the paramount concern with immediate access to funds then the overnight or call accounts are the most appropriate investment option.
In reality, very few funds have such a requirement and some term or maturity preference is appropriate for a liquidity fund. This is in order to avoid the volatility of the overnight rates in the money markets, although the recent Bank of England changes may help to reduce some of the rate volatility in this market. The rate volatility in the sterling money has also generally been declining in recent years.
In terms of attaining high yielding performance, it is important to understand and set open and clear risk targets in any fund specification, which may include limits on maturities, minimum credit ratings, interest rate risk measures and permitted instruments.
Many investment and pension fund trustees have a natural suspicion of the derivatives markets given the poor publicity and losses that some funds and financial institutions have suffered in the past ten years. However, these instruments can play an important part in enhancing yield within a portfolio. There is a caveat to this in that the use of such derivative instruments has to be executed by qualified treasury personnel and allied with experienced accounting and administrative expertise.
Once, a clear risk appetite has been developed in a portfolio then the process of portfolio construction can go ahead. There will be a need for diversification of credits as well as instruments and maturities. All of these will have to assess against the expected life of the fund or desired amount of liquidity.
The growth of the AAA money market funds in Europe is a trend that demonstrates there is a market demand for liquid vehicles with strong credit ratings and competitive yields compared to other instruments such as commercial paper, CDs and call accounts in the major traded currencies.
They represent another clear alternative to the Corporate Treasurer or pension fund trustee in the investment arena. They are suited to cash rich institutions that desire liquidity and wish to use third party treasury expertise and scale.
Segregated cash funds with particular fund requirements can also be developed for external clients, which can give higher yields depending on risk appetites for those funds.
Many companies may wish to utilise their existing in house Treasury functions to manage their liquidity and each entity has its own particular requirements. However, the range of liquidity management tools has expanded and the variety and yield available from the fund management industry gives a wide degree of choice for all risk appetites.
• Liquidity management has raised its profile in the fund management world over the last few years.
• Once risk parameters have been established, a liquid portfolio can be built to meet these.
• Growth of money market funds in Europe suggests demand for liquid vehicles.
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