As with equity markets, retail and institutional investors tend to asset allocate at different points in the cycle from each other and use very different types of vehicle
How have retail and institutional investors managed their cash over the last five years? Very differently, as their specific aims and needs mean that they employ very different approaches to asset allocation.
Retail investors responded to the collapse of the equity markets in 2000 by cutting their losses and reallocating a significant proportion of those assets into cash products, such as money market funds. More recently, they have reallocated their assets back into equities as they have rediscovered their appetite for risk and have been discouraged by the low levels of yield currently offered by cash.
Institutional investors, such as corporates, found that cash became scarce as a consequence of the equity collapse in 2000 and therefore had little interest in cash management products. Subsequent corporate accounting scandals then forced companies to focus on repairing their balance sheets, with the result that they have become very cash rich.
In the US, cash on the balance sheets of companies in the S&P 500 at the end of the third quarter 2004 stood at $590bn, up 126% from the $261bn that they held at the end of 1999. Increasingly, firms have been seeking to manage this cash and achieve an optimal balance between liquidity, security and yield. As a result, such products have seen significant recent inflows.
The graph below illustrates how, although investors have poured significant amounts of money into equity products, assets in cash management products have still grown as a result of liquidity fund growth.
Liquidity and capital preservation
What retail and institutional investors have in common is their need for liquidity and capital preservation. Where they differ is the level of sophistication required in the management of their cash and the products that they typically use. Traditionally, retail investors have opted for money market funds to obtain a return greater than that available on deposit, while at the same time ensuring capital preservation. Institutional investors, on the other hand, are now increasingly using liquidity products to park their cash as well as using a range of money market, enhanced cash and short duration products to enhance their yield returns (see Table 1). Corporate treasurers, for example, are motivated by their need to balance operating cash and core cash requirements. Operating cash needs to be easily accessible, as it is used to meet expected obligations, whereas core cash is generally used for future strategic purposes.
Table 1 shows the different characteristics of cash management products with each vehicle representing a gradual increase in risk and return. All four products have capital preservation and liquidity as overriding objectives and seek to maintain a credit quality that is equal to or better than bank risk. However, they differ in terms of their ability to provide extra yield and time horizon required to achieve it.
Liquidity products have the lowest level of interest rate risk of the four product types and provide an alternative to bank deposits. They invest in bank deposits and securities such as government bonds, commercial paper, certificates of deposit, short-term bonds, floating rate notes, asset and mortgage backed securities and repurchase agreements. They provide deposit-based returns, a high degree of liquidity, stability of principal and give investors a fully diversified portfolio that a deposit with a single counterparty bank does not.
Money market products offer a return above that available on deposit. They achieve a degree of yield enhancement by increasing both interest rate risk, with investment in fixed rate securities out to one year, and credit risk by investing in FRNs (floating rate notes). That retail investors predominantly use money products, while institutional investors use liquidity products, can mostly be explained by the respective structures of the products and different investment horizons of the investors.
Retail investors view investments in money market funds as a part of their asset allocation decision, with an investment horizon of several years. Liquidity products, however, are seen by institutional investors as a means of parking cash in the short term. They have same day trading and generally have a rating such as 'AAAm' from Standard & Poor's. They are also monitored by rating agencies to ensure that weighted average maturity (duration) does not exceed a specified number of days, typically 60, and have a minimum investment level geared towards institutional investors.
Enhanced cash funds offer yields above those of money market products by assuming greater interest rate risk via a longer investment horizon, typically approaching one year. Finally, short duration products embrace the very short end of the bond market. They are suitable for investors who have an investment horizon of three years or longer and are comfortable with the possibility of absolute negative returns for short periods of time.
As alluded to in the descriptions of the products above, yield enhancement can be achieved primarily by extending duration, and also by adding some credit exposure. For many investors, even extending the duration of the portfolios to one year can provide a substantial yield enhancement without adding significant volatility. The yield advantage gained is the result of money market mutual funds not being able to invest in cash securities longer than 13 months. There is therefore less demand for these securities, and so they benefit from more favourable pricing. Table 2 shows the potential benefits of extending duration by comparing the historical risk/return of different types of US Treasury securities.
Duration-focused allocation strategy
Increasing the level of sophistication, a corporate treasurer could pursue a duration-focused allocation strategy. This would involve projecting the time horizon for a company's cash needs and developing tiered portfolios, with holding periods based on the availability of reserves. Such a strategy would help reduce the constraints of investing in longer duration securities, as the investment's maturity would be timed to coincide with the need for future liquidity.
In summary, cash products offer liquidity, safety of principal and the ability to enhance yield over and above that available on bank deposits. Liquidity products are specifically designed for institutional investors seeking to manage their operating cash needs, whereas money market funds are designed to offer a safe haven for all investors in uncertain markets. Enhanced core and short duration funds offer both retail and institutional investors enhanced yield for a commensurately little extra volatility.
Retail investors moved from equities to cash in 2000 and have since reversed the trend
Institutional investors had little money spare post 2000, repaired their balance sheets and are now cash-rich. The result is they are piling in to liquidity products
Four basic cash management products in the market, each focuses on capital preservation, liquidity, sound credit quality but each tends to have different time horizons and yield
As a rule of thumb the longer the investment horizon, the lower the credit quality and the higher the target return.
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