Different MMFs for Alternative Treasury Goals
European money market fund (MMF) assets under management grew by 40% to over US$350bn in 2006. MMFs still represent only 4% of European broad money supply (M3), compared to 25% of M3 in the US. There is therefore a huge amount of as yet untapped potential for these funds and related vehicles – indeed, MMF assets under management are predicted by some analysts to reach US$1 trillion within five years.
There has recently been a significant ‘status upgrade’ for some MMFs. In particular, the regulatory environment has become more favourable to such funds and made them more accessible to potential clients. As a consequence of the European Union’s Capital Requirements Directive (CRD), many MMFs with an AAA rating are being put in line with bank deposits in terms of regulatory treatment. Furthermore, from November this year, custodians holding client money will be able to place it in certain MMFs under the Markets in Financial Instruments Directive (MiFID), rather then being restricted to bank deposits.
Increasing sophistication in the area of corporate treasury – and an increasing pot of available cash (in August 2006, 26% of European companies had more than €100m liquidity) – means that the range of investments available to treasurers is constantly broadening. This process is demand-driven, as more corporate treasurers begin to manage their cash balances more actively and look for increased yield opportunities.
Broadly speaking, MMFs can be grouped together according to level of liquidity they provide, the amount of risk they take and therefore the return they produce. Although the regulatory changes discussed earlier have recently provided some clear-cut boundaries within this range, cash funds form a continuous spectrum in terms of this liquidity, risk and yield rather than falling into strict categories.
The key as far as corporate treasurers are concerned is to match the risk and return profiles of these widely varying funds with their company’s specific requirements in terms of cash management. How soon might invested cash be required, and at what notice? What is the company’s level of risk appetite? Is the company prepared to tolerate more volatile returns in exchange for increased yield? The answers to these questions will determine which combination of investments will best suit these requirements.
At one end of the spectrum are liquidity funds, which invest exclusively in high credit quality and liquid investments. This type of fund has a typical weighted average maturity of 60 days or less, and provides daily liquidity as well as a stable net asset value (NAV). Although they are the most restrictive in terms of available investments, these ‘dollar in, dollar out’ funds, by virtue of their cash-like liquidity, provide a safe haven for working or ‘operating’ capital – cash a company is likely to need instant access to in the short term. For this type of cash, preservation of capital takes precedence over yield, and these funds aim to provide a yield equal to or slightly higher than a bank deposit.
Further along the spectrum lie ‘cash plus’ funds, which are less precisely defined in terms of the range of allowable investments. These funds may invest in more illiquid instruments of slightly lesser credit quality, extend portfolio maturity further out onto the yield curve, or sacrifice same-day liquidity to aim to produce higher returns. As a consequence, the value of investments in these funds may be more volatile than in a liquidity fund, making cash plus funds suited to ‘core’ capital that a company is prepared to lock away for a longer period of time, say six to 12 months.
Enhanced-cash funds are positioned further still along the risk-return spectrum. Here the emphasis is very much on generating maximum yield, while preserving capital and some degree of liquidity. Enhanced-cash funds invest a portion of their assets in riskier, more volatile or less liquid investments, such as asset- and mortgage-backed securities, or apply less stringent restrictions on the credit quality of their investments in order to boost returns. In addition, many fund managers make use of derivatives and cross-currency investments. A consequence of this – in addition to the expected enhanced yield – is a markedly more volatile NAV. For this very reason, enhanced-cash funds are suited to corporate treasurers with a longer-term view of at least a year, and to more ‘strategic’ cash balances that are unlikely to be dipped into over this horizon. Much more than for liquidity or cash plus funds, there may be considerable variation between different enhanced-cash funds in terms of composition and risk exposure, depending on the manager.
While selection of a liquidity fund – where yields among the peer group may only differ by a few basis points – may depend more on such criteria as late investment cut-off times or management fees, the selection of an enhanced-cash fund constitutes a significantly more technical decision based on the company’s own investment outlook.
The choice of which fund or funds to invest in – liquidity, cash plus, enhanced-cash – will therefore be determined by the nature of the cash a treasurer has available to invest: operating, core, strategic or some combination of these. Accurate cash flow forecasting is thus of the essence: strategic cash that is not needed in the short term may not provide the best available return in a liquidity fund, while the less liquid and more volatile enhanced-cash funds are unlikely to be suitable for operating cash that needs to be immediately available.
As corporate earnings continue to grow, so does the pool of cash available on corporate balance sheets. The range of investors using MMFs is broadening as well: in addition to the corporate treasurers that have long constituted the bulk of investors, pension funds are also turning to MMFs. Indeed, pension fund liability-driven investment (LDI) strategies often require cash to be available as collateral on swap transactions, making liquid MMFs an attractive parking space for this cash.
With the regulatory changes highlighted earlier coming into force this year, there is likely to be continued growth across the range of MMFs as more treasurers seek to invest more cash in an asset class that is attracting ever more attention.