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| Risk & Reward: Strategy |
Alternatives to the Mattress
John Ferry
02/01/2007
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Wealth advisors often tell their
clients to keep a certain proportion of their portfolio in cash. Although the
long-term returns on most cash investments are minimal (and, with inflation
taken into account, they can be negative in real terms), they are beneficial
because they dampen a portfolio’s volatility. But investors can now manage and
invest their cash more effectively.
TOP VIEW
Rather than keeping piles of cash in low-yield deposit accounts,
investors can put money into enhanced cash products (ECPs), which seek to
outperform money market funds by taking modest amounts of interest rate, credit
and liquidity risk in the fixed-income markets. Liquidity, however, is the cost;
ECPs lock up investors’ cash for anywhere from six months to a year. |
"We regularly ask affluent clients how much readily available
cash they actually need, because daily liquidity comes at a cost," says John
Krieg, director of product management at Northern Trust in Chicago. To reduce
this cost, investors can put their cash into a number of instruments, from very
safe money market funds to products that behave like short-term bond funds.
Slightly more risky than both of these is a new breed of
instrument known as enhanced cash products (ECPs)—also called enhanced yield,
cash-plus or Libor-plus. These invest in a wider range of securities than money
market funds, and therefore offer a higher return. Most providers package them
as mutual funds, although some, including Northern Trust, offer them on a
separate account basis.
These products became popular during the recent low-rate
environment. "In 2002, the Federal Reserve lowered rates to 1 percent and left
it there for a while, which really got the whole enhanced cash market going,"
says Lyman Missimer, Houston-based chief investment officer for cash management
at AIM Trimark Investments. "All of a sudden, you had all these money market
investors looking at 1 percent returns and trying to figure out where else they
could get yield." Institutional investors were the first to use ECPs, but
wealthy private investors have also found them advantageous.
ECPs outperform money market funds by taking modest amounts of
interest rate, credit and liquidity risk in the fixed-income markets. "In
essence, you are giving up daily liquidity for a little more total return,"
Krieg says. "You’re picking up the benefit of higher yields by going a little
lower in quality and a little longer in maturity."
Enhanced Figures
One difficulty when choosing among ECPs is the lack of a
standard definition. Some managers refer to enhanced cash products as anything
on the fixed-income risk spectrum between money market products and ultrashort
bond funds. Others only include products that are slightly riskier than money
market funds. However, the common ground for all enhanced cash products is that
their underlying investments are slightly longer-dated than those used in money
market funds, and may include fixed and floating-rate agency debt, corporate
bonds or asset-backed securities.
According to Krieg, ECP managers limit holdings to securities
with a credit rating of at least A or better, and seek to have their portfolio
average around AA—one step below the highest quality. Managers try to boost
their yields by forsaking AAA-rated issues and finding undervalued securities,
Krieg says. There is definitely a trading element to the products, he adds,
which distinguishes them from the more standard buy-and-hold approach of money
market portfolio managers.
Money market funds are governed by SEC rule 2a-7. This
restricts them to short-term government securities, certificates of deposit and
corporate commercial paper, with a tenor of less than 13 months. The funds must
maintain a constant net asset value (NAV) of $1 per share—for every dollar you
put in, you get a single share in return. This ratio cannot change.
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