Optimizing Returns Through An Efficient Short-Term Investment Portfolio
Inadequate short-term portfolio management leads to increased opportunity costs, especially under favorable economic conditions. In order to avoid the opportunity costs associated with an inadequate short-term investment strategy, management should consider various investment instruments and maturities in the liquidity allocation process, the result of which is a short-term investment portfolio. A short-term investment portfolio that yields the highest return given investment policy risk constraints is an efficient short-term investment portfolio. Moreover, an efficient short-term investment portfolio drives revenue and reduces risk.
The opportunity cost of an inadequate short-term investment strategy increases as a firm’s liquidity balance and the level of interest rates grow. Some drivers of opportunity cost include inefficient or absent cash forecasting methods, an inadequate investment policy, idle balances, cash management inefficiencies and a lack of diversification.
Management is better able to make profitable decisions given cash forecasting output. Forecasting influences decision-making by providing management with data concerning the availability of cash over various timeframes. Given this data, the decision maker is able to better predict the availability of investable cash, and can utilize short-term investment vehicles with longer maturities. When a firm does not have reliable cash forecasting resources, management is unable to accurately predict cash balances. Inaccuracy or the inability to predict cash balances leads to opportunity cost, as management is unable to leverage forecasting data to segregate cash into different maturity pools and invest in extended maturity instruments that offer higher yields. The result is a missed revenue opportunity, or increased costs associated with overdraft fees, credit, or liquidation penalties.
The firm’s investment policy determines the risk and return profile for short-term investment decisions. The risk profile filters investment instruments that are unacceptable to the firm’s policy while the return measure sets the benchmark for management in terms of required return on short-term investments. An outdated investment policy results in inadequate investment performance. Failure to regularly adjust the risk profile leads to either overly risky investments, or investment decisions that under perform due to an overly sensitive investment instrument filtering process. Likewise, failure to adjust the return benchmark can cause management to exhibit overly risky short-term investment decisions in a low interest rate environment in an effort to reach a benchmark that was set in a time of high interest rates. Conversely, management may not take the initiative to enhance short-term yield in a favorable environment because the outdated benchmark is comparatively low given current market conditions.
Although idle balances can typically provide earnings credit, the opportunity to earn a competitive rate of return must be factored into the firm’s overall investment strategy. Cash managers that neglect the opportunity to earn return on the cash position risk having an inadequate short-term investment strategy, and also risk high opportunity costs associated with the firm’s liquidity.
Inefficient cash management not only leads to the inability to determine balance, but also to the failure to forecast the cash position. As previously mentioned, cash forecasting enables management to increase yield through maturity extension. Therefore, cash management inefficiencies result in an opportunity cost to the firm through the inability to measure the balance as well as the inability to capitalize on maturity extension. Moreover, cash managers that are unable to determine the cash balance of the firm are unlikely to capitalize on the revenue generated from scaled investments with larger balances. Finally, firms that cannot concentrate balances risk holding pockets of trapped cash, which results in increased opportunity costs.
A decentralized account setup can also lead to inefficiencies. A decentralized account structure leads to cash management difficulties through data handling complexities as well as regional investment decision-making. The data issue negatively impacts cash forecasting and balance reporting, and regional investment decision-making can lead to opportunity costs by not capitalizing on scaled short-term investments.
Lack of diversification in the underlying short-term investment portfolio can lead to unwanted risk and decreased yields. Concentration risk can negatively impact the risk profile of a firm. For example, if a firm relies too heavily on bank deposit products, then the firm is exposed to concentration risk. Concentration risk is only a portion of the overall risk associated with concentrated investment decisions – a firm also risks a lower rate of return on invested liquidity. This is a concern, especially in markets where interest rates are moving. In increasing rate environments, deposit products react more quickly to interest rate changes while money market mutual funds typically lag. In decreasing rate environments, money-market mutual funds typically outperform deposit products. Finally, a firm must diversify short-term investment products in an effort to reduce exposure to the performance of any one instrument.
Inadequate short-term investment strategies typically lead to lower return, unwanted risk, and increased opportunity costs. The key to return optimization is to establish a centralized and integrated liquidity management process, resulting in a short-term investment portfolio that achieves the highest possible return given the risk parameters designated by the firm’s investment policy. The benefits of this approach include a reduction in overall risk, enhanced yield, and increased investment performance via instrument diversification and maturity extension.
A firm can optimize the short-term investment strategy by taking the necessary steps to maximize return given risk constraints, thereby achieving an efficient short-term investment portfolio. In order to establish the most efficient short-term investment portfolio in terms of risk and return, the firm must include the following tasks into the overall liquidity management process:
Bank centralization is an important topic in the cash management world. A properly executed centralization strategy can lead to the control that is required for effective cash management, especially when it comes to short-term investment decision-making. Centralization typically results in efficient account data management, which provides management access to relevant and dependable data. This provides the basis of profitable short-term investment decision-making.
Principal is a driver of investment performance. A firm can increase scale and invest a greater amount through balance concentration. It is therefore important to partner with a bank that is able to provide balance concentration services. Typically, balance concentration functionality includes third-party drawdowns, balance pooling, and netting. The execution of third-party drawdowns is an effective way to concentrate balances across the firm’s cash account network. Balance pooling allows a firm to capitalize on scaled investment opportunities by aggregating balances across the account network. Account netting automatically funds overdrawn accounts before aggregating and calculating the investable balance. An ideal banking partnership will provide firms with the structure and functionality to concentrate funds across accounts, net negative and positive positions, and scale balances to enhance yields and increase revenues.
An investment policy sets the risk/return profile for the firm’s short-term investment process. Risk limitations filter acceptable investment instruments from the pool of money-market investment options. The return profile sets the benchmark that measures the performance of short-term investment decisions. It is therefore important to maintain an updated investment policy in an effort to ensure that the risk constraints and performance measurement standards of the firm’s investment policy captures current market trends as they relate to the risk/return profiles of various instruments. An updated investment policy enables management to utilize the investment resources necessary to achieve an appropriate level of return given current market conditions.
Risk constraints must factor levels of liquidity and solvency that are required for the performance measurement of a firm in specific industries. Debt covenants and financial performance ratios dictate required levels of liquidity, while banks must factor solvency measurements. For example, the Basel II accord establishes regulatory guidelines for capital reserves within a bank. Basel II provisions may result in regulatory capital relief and operational risk reduction through AAA-rated money market mutual fund investments and collateralized credit incentives. An updated investment policy must therefore factor AAA money market mutual fund investment options and collateralized market (triparty repo) exposure to capitalize on capital charge reductions and overall yield enhancement opportunities.
The return benchmark must factor both current market trends and average portfolio maturity. Management should consider leveraging widely used market barometers such as the term structure of interest rates (US Treasury, LIBOR, etc.) and tracking a point in the structure that matches the average maturity of the short-term investment portfolio. This will ensure that the benchmark is up to date and relative to market conditions.
Both balance and maturity drive return; therefore, it is important for management to be able to call on balance data in an effort to determine investment parameters for portfolio allocation decisions. The instrument decision is driven by the aforementioned policy, while cash forecasting data drives the maturity decision. The timely availability of balance and forecasting data provides decision makers with the information required to make informed short-term investment decisions. Balance data combined with reliable forecasting data allows cash managers to segregate liquidity into different cash pools – operational cash is needed for day-to-day liquidity, while the other cash pools can be segregated into different segments based on the length of time the cash can sit before it is needed for daily liquidity use. In cases where forecasts show large cash balances and non-operating cash pools, management can increase yield by investing in extended maturity money-market instruments. Management can also benefit from balance data by investing in higher-yielding instruments with large minimum investable balances.
The breadth of money market investment options poses challenges for a cash management professional tasked with allocating capital across an array of short-term investment instruments. The investment policy will aid in this step, as investment vehicles must meet the risk/return profile of the policy; therefore, the decision maker is left with only a subset of money market instruments. After filtering the investment choices, it is important to consider factors such as investment cut-off times, access to liquidity, the impact of market movements on an investment’s return, and secondary market liquidity. Cash forecasting and balance analysis will help decision makers efficiently allocate funds across the spectrum of available money market instruments. The benefits of allocating capital across various investment instruments are yield enhancement and risk reduction.
Separating daily liquidity and longer-term liquidity into different pools leads to enhanced yield. Operational liquidity can be invested in overnight-investment instruments with late investment cutoff and early morning redemption, such as offshore deposits. Longer-term liquidity (cash not needed for operational activity) can be placed in instruments that offer higher yield in return for extended maturity, such as auction rate securities and CDARS. Diversification reduces investment performance risk and concentration risk. By diversifying the short-term investment portfolio, overall revenue performance is spread across various instruments. Short-term investment portfolio diversification also reduces concentration risk that can result from bank centralization. By allocating funds across an array of investment instruments including off-balance-sheet investments, concentration risk is reduced, and the firm can still capitalize on the benefits of centralizing cash management with one provider.
The final step in developing an efficient portfolio is executing the capital allocation process. The most efficient way to allocate capital across an array of money market instruments is to partner with a bank that offers product breadth and complementary cash management services. Banks offer money market access and have a wide product offering that can meet investment demand. By incorporating cash management and investment execution, concentration balances can be easily accessed and investment redemptions are handled in an efficient and timely manner. Banks offer value added account management services that complement the investment decision process. Intraday and end-of-day sweep functionality is an efficient way to manage capital and invest in various instruments in the sweep program. Banks typically offer account netting/pooling, as well as deposit product sweeps, money market mutual fund sweeps, and a host of repo and short-term fixed income sweeps that meet the risk/return profile of most investment policies. Some banks offer custody services for investment options like money-market mutual funds and triparty repo. Finally, banks are uniquely positioned to automate the investment execution process, which integrates cash and investment management decisions, and ultimately results in the most efficient solution for a firm’s short-term portfolio allocation process.
Inefficient cash forecasting, cash management deficiencies, an outdated investment policy, idle balances, and inadequate investment allocation processes, drives the opportunity cost of inadequate short-term portfolio management. To achieve an efficient short-term investment portfolio, management must improve the short-term investment process. An efficient short-term investment portfolio will reduce overall risk through diversification while increasing revenue through enhanced return. Management should centralize the banking relationship, concentrate funds, maintain an updated investment policy, leverage balance and cash forecasting data, make portfolio allocation decisions, and efficiently execute the fund allocation process through a banking partner. If followed properly, the cash management professional should ultimately have an optimal short-term investment strategy that will lead to an efficient short-term investment portfolio, reduced risk, and increased return.