Liquidity Funds Hit Their Stride
Liquidity funds have the advantage of being run by a dedicated manager who constructs a portfolio of very short-term investments to be as profitable and efficient as possible. They take into account as much information as they can find about potential future cash flows in and out of the fund, depending on the source of the money invested. This knowledge is then combined with the fund manager’s view on interest rates to determine the underlying investment decisions in the fund. Cash flow forecasting is therefore a key part of liquidity fund management, to optimise fund construction and investment decisions. In essence liquidity funds enable treasurers to outsource their short-term cash management duties to expert cash managers.
Liquidity funds provide a valid alternative to bank accounts for depositing short-term cash surpluses. They allow cash to be highly accessible at all times and large liquidity fund providers even offer online services that are very similar to normal online banking sites, where investors can see their balances on screen and execute transactions.
One important benefit of investing in liquidity funds, rather than a bank account, is risk limitation. Unlike bank deposits, the risk to money invested in liquidity funds is spread across dozens of different securities. Credit is diversified and volatility reduced through a broad portfolio mix, with a maximum of 5% of the fund placed with any one issuer and diversified across industries. In addition, the weighted average maturity of a portfolio is less than 60 days. The securities in which liquidity funds are invested can help many funds obtain a top quality AAA rating from Moody’s, Standard and Poor’s and Fitch. Contrast this with banks, whose own ratings are typically AA or worse. To avoid counterparty risk, some investors may choose to deposit their short-term cash flows with several different banks but compared to liquidity funds this could be time consuming and bank deposits will still retain aspects of sector and systemic risk.
Secondly, the return on short-term cash investments may be higher in liquidity funds than for bank deposits. The yield potential for bank deposits is extremely limited but, in contrast, liquidity funds are designed to maximise returns. Liquidity funds take advantage of their economies of scale to minimise costs and enhance yield through a larger asset pool. In standard market conditions, when the yield curve is not flat, fund managers can invest in underlying securities with longer durations to increase a portfolio’s yield. In addition, liquidity fund investments do not incur the custody and settlement expenses or rolling and breakage costs that are associated with bank deposits. Instead, once a month, investors receive a dividend that has accrued over the month, net of a small published management fee, with no further subscription or redemption fees.
Furthermore, while money on deposit must be reinvested daily to retain short term liquidity, investors in liquidity funds are spared this laborious task. Instead liquidity funds are actively managed based on credit and macro research, and investors can leave their cash to grow in the fund until it is required.
One differentiator between liquidity funds and enhanced yield funds is the duration of the investment, which means they are suitable for different purposes. Money invested in liquidity funds is typically working capital that may need to be accessed at a moment’s notice, whereas funds not required to meet day to day working capital requirements can be put into an enhanced yield fund, which offers a solution further along the yield curve.
Flows that are invested in liquidity funds typically are invested for a day or more and the capital is invested in extremely high quality securities, as outlined above. Enhanced yield funds, on the other hand, can add value to money that can be invested for longer time periods, over and above liquidity funds. The investments are generally held for several months or more and are still highly rated but do not need to adhere to such strict regulations as liquidity funds. Whilst enhanced yield fund portfolio managers have a greater flexibility to employ different strategies in the construction of their fund to optimise returns, they generally expect investors to hold their investments over a longer time horizon.
US investors have been able to access liquidity funds for over 30 years, creating a market that is now worth around US$2 trillion. North American treasurers are far more likely than their European counterparts to use direct and pooled investments, and US cash investors traditionally have used MMFs for their excess cash requirements rather than bank deposits.
The liquidity fund market is much newer in Europe, but it has been growing at roughly 50% a year, to develop over a decade from nothing to a total market size of US$477bn (for 4 May 2007). Unprecedented high levels of cash on corporate balance sheets, European legislation such as Basel II that promotes favourable treatment of highly rated funds and increasing merger and acquisition activity are potential drivers behind the surge in European demand for very liquid strategies. Demand in recent years has also led to the creation of many other markets, particularly in Asia and South America, with the development of local currency liquidity funds.
The core fund denominations in Europe remain euros, US dollars and pounds sterling. To demonstrate the share of funds across denominations, JPMorgan in Europe has a market share of 18%, with over US$87bn under management for the three core currencies. Of this amount, approximately 72% is in US dollars, 18% is in euros, and 10% in pounds sterling. Unlike some other investment vehicles, fund size is very important for liquidity funds. Large funds provide the huge benefit that they can absorb very large fund flows without liquidity concerns.
The most appropriate money market strategy is often a blended approach. Short term funds that may be required at a moment’s notice and need to be secure could be invested in AAA-rated liquidity funds, whilst more flexible short term cash flows can be placed in enhanced yield funds. Other cash surpluses may be channelled into other short-term investment strategies. This tailored method should maximise returns on the investment available, given the various time horizon constraints.
Liquidity funds definitely have a place in the money market family as a secure, liquid and return maximising strategy. Investment decision-making is performed by a liquidity fund manager, who uses all of the information at his disposal to create a fund that is most suited to his clients’ needs.