The smart investor exploits anomalies in the market to boost earnings with Oeic and Isa cash funds, says Paul Gibbs
When Threadneedle launched the UK Money Securities Fund in August 1997, it was the first money fund structured as part of an Open-ended investment company (Oeic). Now valued at over £130m, the fund aims to provide a secure haven for clients seeking security of capital with a competitive rate of interest.
An FSA authorised cash fund can be operated either as an Oeic or as a cash unit trust. The rules are not the same ' even though both have the same sort of purpose.
The Oeic structure is operated within the definition of 'securities funds', and a cash unit trust is operated within the definition of 'money market funds'. The reason is that Oeics currently derive their investment powers from the European funds directive (Ucits), as the Government could not find time for separate legislation for their introduction. This means Oeics can only invest in traded securities and not in cash deposits.
The unit trust rules precede the Oeic rules and do allow funds putting cash on deposit to be sold in the UK. But these funds, unlike Oeic money funds, cannot be registered for sale outside the UK under the UCITS Directive as this right extends to funds investing solely in securities.
This difference in regulatory framework determines how a fund manager achieves security, return and liquidity. A cash unit trust is permitted to place deposits with banks and building societies, with investment being limited to a maximum of 20% with certain institutions.
It can also place deposits or hold loan notes with a maximum duration to maturity of 12 months ' but it must ensure that at least 50% of the fund's assets are redeemable or repayable within two weeks. Security of capital is provided by making deposits only with borrowers of the highest credit rating, and by limiting the amount of the fund exposed to any one borrower.
Since higher returns may be achieved on larger investments, this means it is important for a cash fund to achieve a critical size
An Oeic has to invest in 'transferable securities'. Because the Oeic is a securities fund, investment in the securities of any one issuer is generally limited to 5% but may rise to 10% in limited circumstances.
This means diversification is achieved by investment with a minimum of sixteen holdings. It is not limited to having 50% of assets redeemable in a fortnight and so can hold more in longer-dated, higher-yielding securities.
Allowing greater scope
So the Oeic structure does provide the fund manager with greater scope to hold longer dated paper and achieve some extra return and the effect of the FSA regulations is to require a higher level of diversification.
One further difference is for cash Isas. The rules for cash Isas demand that, in order to qualify for inclusion, any fund must have the majority of its assets on deposit. This means that unit trust funds can qualify for inclusion but that Oeic funds cannot.
The refusal of the Inland Revenue to review this requirement is extremely irksome as the greater flexibility of securities funds provides a slightly better opportunity to achieve returns and the additional diversification can be used to reduce risk.
Putting money on deposit is not too onerous; achieving additional returns on a money securities fund is more complex. The first task is to ensure both liquidity and capital security. Liquidity is essential to be able to cover any daily outflows from the fund without being forced to sell securities at market bid rates. Capital security, of course, means avoiding investing in anything where a 'credit event' might result in a rating downgrade or default. The secondary task for the manager, having satisfied these two primary objectives, is to maximise the returns provided by the fund.
Preparing for success
Before selecting investments, Threadneedle believes there are a number of prerequisites for success.
First, you need a prospectus that makes the limits clear in terms of what is allowed, in relation to credit ratings for example. In addition, the manager needs clear guidelines in terms of credit risk, maturity and mix of asset types.
It is important to identify a clear benchmark against which the fund's performance will be measured. This will typically be one-month or three-month deposit bid rate, or London inter-bank bid rate (LIBID).
To monitor risk, you should have an independent monitoring system to control counterparty credit exposure on a daily basis. And finally the manager must have the necessary infrastructure: this includes back-office accounting, valuation and settlement capabilities, and front-office dealing support systems. There are a number of considerations in choosing investments for a money fund. If you put money on deposit you will usually get a better return the longer the term. But of course, the money will not be liquid because you cannot trade a deposit ' you have to wait to maturity.
If you buy fixed rate paper, the longer the maturity the better the return ' usually. But this allows more scope for capital fluctuation before redemption. And if you buy commercial paper or deposit with fringe banks, you may get a better return, but there is more chance of default. The skill of the manager lies in balancing these different considerations.
Possible investments include:
l Treasury bills (issued by governments). Low-yielding but with high liquidity and no credit risk.
l Repo (effectively a deposit secured by treasury bonds or other low-risk assets). Also low-yielding but with very little risk.
l Bank deposits. Yielding at or close to LIBID (depending on the credit rating of the bank).
l Bank certificates of deposit (CDs). Transferable securities, and because they are more liquid than straight time deposits, the yield is correspondingly lower.
l Commercial paper. Unsecured IOUs issued by banks and corporate names. They typically yield slightly higher than CDs, and are slightly less liquid. Lower-rated paper gives a significant yield pick-up over higher-rated issues.
l Floating-rate notes. Longer dated bonds whose interest-rate is re-set at regular intervals (one, three or six months). They therefore combine long-term funding (for the issuer) with price stability (for the investor). They are less liquid than other instruments but typically yield more than the market offer rate. This can vary from less than five basis points (bp) for highly-rated, short maturity (less than two years) paper issued by banks, to over 100bp for lower-rated, longer dated corporate issues.
Achieving superior fund performance is really about two things: yield-curve management and credit-risk management.
Making the average maturity of the fund's investments longer has the effect of locking in current rates and is therefore beneficial if you believe rates are going to decline. On the other hand, keeping the maturity short results in having more cash to reinvest in the short term, which is beneficial if you believe rates are going to rise. Fund managers will therefore adjust the average maturity of the fund according to their view of how money-market interest rates will change.
Credit risk management is really about exploiting anomalies in the market and taking advantage of mispriced credit. These anomalies can occur because of distortions caused by regulatory factors, for example, such as different definitions of asset quality in different jurisdictions.
Or the fact that ratings agencies such as Standard & Poor's analyse securities for up to twelve months, whereas many money-market funds buy paper on only a one-month month view.
Bearing all this in mind, our investment approach is first of all to ensure adequate liquidity by keeping about 10% of the fund available to meet daily cash flows. This usually means 5% on overnight deposit and the other 5% by having a conservatively structured 'maturity ladder' so there are at least some securities maturing every day.
Second, we have a high proportion of the fund in floating rate notes to take advantage of the high yield.
Although these assets are less liquid in the sense that they are not traded actively, they are liquid from an investor's point of view, because there is always a good bid in the market.
Last, we invest judiciously in very short dated lower-rated (but still investment grade) commercial paper ' Allied Domecq, Anglo-Irish Bank, ICI, Powergen & Volvo, for example.
The fund breakdown is typically 50% floating rate notes, 35% short-dated commercial paper, 10% longer dated high quality certificates of deposit, and 5% overnight bank deposits.
An FSA-authorised cash fund can be opened either as an Oeic or a cash unit trust.
A cash unit trust is permitted to place deposits with banks or building societies.
Cash Isas must have a majority of assets on deposit.
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