While the experts are busy debating the use of cash in client portfolios, there is another less obvious debate going on about exactly what ‘cash’ means when it comes to investment funds.
Like so many other investment products in the past decade, simple cash funds have morphed from straightforward ‘pure cash’ into ‘enhanced cash’ funds that often contain investments far removed from most ordinary people’s definition of cash.
Most cash or money market funds typically invest in high quality, short-term instruments with a AAA rating. These include short duration bank accepted bills, commercial paper, semi-government promissory notes, floating rate notes and call and term deposits.
Enhanced cash funds hold similar assets but have sought to add extra return by investing in lower-rated commercial paper, asset-backed commercial paper and mortgage-backed securities.
Pimco’s US-based senior vice-president Paul Reisz explained the change in a recent article.
“Over the past few years, the securities that money market and enhanced cash strategies traditionally hold were providing low yields and low risk premiums compared to historical levels. This led many managers to search for alternative sources of high-quality yield in cash portfolios … Investors thought they were taking little risk in their money market and enhanced cash strategies.”
Until last year the distinctions seemed small, but with the arrival of the credit crunch they became a major point of difference that led some enhanced cash funds — both in Australia and internationally — to lose value.
This came as a painful surprise to many investors — and investment managers.
“The unexpected volatility that some money market and enhanced cash strategies have experienced has brought the realisation that managing cash is not as simple as it may seem,” Reisz noted.
In Australia, some enhanced cash investors and superannuation fund members were badly burned when the liquidity crunch froze markets.
The latest cash and enhanced cash subsector review from Standard & Poor’s (S&P) Fund Services points out that while the enhanced cash funds it rated performed well against the UBS Bank Bill Index, “the broader enhanced cash category delivered disappointing results”.
According to Vanguard Investments Australia head of fixed interest, Roger McIntosh, enhanced cash investors have been disappointed.
“I think it is tragic when you see negative returns from a cash product,” he said.
NAB Personal Banking executive general manager, consumer product solutions, John Salamito, agreed negative returns are inconsistent with most clients’ view of cash. “There is no pleasure in seeing clients affected like that.”
Labelling the returns from enhanced cash “from mediocre to ghastly”, McIntosh said Vanguard had avoided the problem by keeping its cash portfolio limited to traditional cash instruments such as bank bills and short-term government instruments.
“Where things ran off the rails is by introducing credit risks into cash. The same thing occurred in bond funds,” he said.
McIntosh believes much of the problem has stemmed from investment managers trying to justify active management in an asset class where it is very difficult to outperform the benchmark.
“It is valuable to have a lot more in passive with fixed interest and cash, as it is much harder to outperform in these asset classes for active managers,” he said.
Attempts by active managers to outperform are part of the explanation for the disappointing results from some enhanced cash products, according to McIntosh.
“We have seen product providers trying to juice up returns with exotics and credit enhancements, but it is very hard to outperform with cash,” he said.
Concern over the losses in some enhanced cash funds has encouraged industry bodies the Investment and Financial Services Association (IFSA) and the Association of Superannuation Funds of Australia (ASFA) to establish a working group to develop better definitions for growth and defensive asset classes.
The working group has circulated a draft paper proposing only cash and fixed interest investments be classified as defensive, with all other assets classified as growth. It has also come up with a draft definition of ‘cash’ and ‘fixed interest/bonds’.
The draft proposal suggests the average duration of cash assets should be less than 180 days, the weighted average credit rating of securities in the portfolio should be AA or higher and less than 5 per cent should be sub-investment grade debt. In addition, cash portfolios must only consist of debt securities, with no use of credit derivatives.
S&P’s director of fund services Jeff Mitchell has been participating in the working group. He believes when the new definitions are finally determined, they will help investors and superannuation fund members better understand exactly how their money is being managed and what can go wrong.
“Investors were taking risks in products they didn’t really realise they were taking,” Mitchell said.
“People are now aware of what is the magnitude of the downside risks and this will increasingly guide the way a portfolio is constructed.”
Macquarie Adviser Services senior product manager cash, Peter Forrest, also agrees there needs to be greater clarity around the use of terms like cash.
“Cash is a secure asset class, but it is important to know what you are investing into,” he said.
