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Cashing In

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With the economy continuing to struggle, and with inflation low–maybe too low–the Federal Reserve will likely keep short rates low for an extended period, perhaps years. In this environment, advisors need to identify risk-conscious strategies that can enhance the performance of the cash portion of an investment portfolio.

When investors construct investment portfolios, they usually devote considerable attention to determining the optimal allocation between stocks and bonds. By contrast, decisions about the cash portion of an investment portfolio are seldom subjected to the same degree of scrutiny. When investors do think about the cash allocation, they tend to consider only a narrow range of traditional investment choices, and it seems that they focus more on equities, which frequently appear at the forefront of the news. Nevertheless, a balanced financial plan should include elements of all three asset classes–equities, bonds, and cash–in order to maximize risk-adjusted returns in an investor’s portfolio.

Financial planners and consultants generally recommend keeping the equivalent of three to six months expenses in a cash reserve. The exact amount that an individual, family, or institution should maintain in a reserve or emergency fund depends on factors such as the outlook for income stability and projected expenses.

The primary goals of a cash portfolio are capital preservation, liquidity, and a competitive rate of return. Money that someone truly needs immediately should be invested in money market accounts, short-term certificates of deposit, or bank savings accounts. Money market funds and bank savings deposits provide principal protection and liquidity, but returns are low. Longer-term CDs and government savings bonds offer a higher yield than money market funds, but this usually is offset by less liquidity in the form of a penalty for cashing out early. If tax avoidance is a priority, then tax-exempt money market funds and short duration municipal debt funds are another alternative.

As of the end of 2002, $2.3 trillion was invested in money market mutual funds and another $2.5 trillion in money market instruments, including bank accounts and bank CDs, according to the Investment Company Institute. This is evidence that many investors believe that cash is the place for a good night’s sleep. Money funds are designed to provide perfect liquidity and to trade with no loss of share value. Nevertheless, there is a range of conservative investment options that over time perform much better than money market funds for investors with a slightly longer time horizon.

Enhanced Cash

Perfect liquidity has its benefits, but it is the enemy of higher returns. Over the long term, it should not matter to investors if their liquid reserves were to fluctuate between 98 to 102 cents on the dollar, as long as they averaged 100. By accepting more volatility, investors can significantly increase their potential for higher returns.

By considering a broader range of short-term investment strategies, investors can exert an increasingly significant impact on portfolio returns. These enhanced cash strategies are designed to improve on returns provided by typical money market vehicles while preserving principal and providing daily liquidity. Strategies that fall in the Lipper “ultrashort obligations” category seek to capture excess returns related to several structural inefficiencies within the short end of the fixed-income yield curve. Lipper “short investment- grade” strategies use a similar approach, but are more appropriate for investors who can accept slightly greater price volatility in pursuit of higher incremental returns. Enhanced cash strategies have greatly outperformed common money market and cash equivalent benchmarks.

When cash is not necessary for immediate needs, these strategies should provide a yield cushion and higher long-term total returns with a minimal increase in risk (price volatility) relative to money market investments. Table 1 shows some examples of such strategies.

Building Portfolios

Enhanced cash investments are designed to be conservative and diversified portfolios that use multiple concurrent strategies in an attempt to generate improved returns over those available in money markets. A significant portion is invested in the same high-quality, short-term securities that are the standard fare of traditional money market funds, such as CDs, Treasury bills and commercial paper. This is combined with an expanded investment opportunity set to generate excess returns over money market strategies.

Structurally, enhanced cash portfolios seek to capture excess returns by investing in four strategies embedded in the short end of the fixed-income yield curve:

o A term premium may accrue to investors for holding securities with slightly longer maturities than those of money market instruments. Increasing the duration of a cash portfolio modestly beyond the typical three-month duration of traditional money market funds has the potential to significantly improve portfolio performance without materially increasing the likelihood of negative returns.

o A credit premium may be obtained by holding a portfolio of securities with diversified credit quality. Blending high-quality AAA and AA holdings with carefully selected bonds rated below AA allows the portfolio to increase yield and improve diversification.

o A liquidity premium may offer incremental yield for holding bonds with wider bid/ask spreads. The inclusion of some higher-yielding but slightly less liquid securities such as floating-rate securities and adjustable-rate mortgages in the portfolio may provide another source of excess return.

o A volatility premium may be available to investors who can tolerate increased principal fluctuations. Many investors pay an excess premium for price stability, as implied short-term market volatility generally is higher than actual realized volatility.

And Now, the Results…

Enhanced cash strategies are structured to generate excess returns over money markets over long periods. Excess returns can be measured in a number of ways. Historically, ultrashort strategies have provided a yield cushion over money markets of 50 to 100 basis points and short investment-grade strategies had an even greater yield advantage of 150 to 250 basis points. Table 2 demonstrates the current yield cushion for these strategies. The cushion is derived from a premium in yield for assuming a modest increase in duration and from active investment in the broader universe of securities available to investors who are not limited by money market restrictions. The yield cushion has the potential to enhance returns and provide a buffer against potential adverse fixed- income price performance.

Yield is not the only measure to use in evaluating enhanced cash strategies, however In general, extended duration and a broader opportunity set of investments may provide enhanced returns over money market strategies as demonstrated in Table 3.

Evaluating Enhanced Cash Strategies

Yield and total return are good starting points in judging how each enhanced cash strategy fits cash flow needs. However, these strategies carry different levels of risk, and the yield and total return do not necessarily translate into outperformance over the benchmark for each strategy. Hence, there are other measures that should be incorporated into an analysis of which strategies are the best fit: risk-adjusted total return; tracking error, and information ratio.

Risk-adjusted total return (yield plus price appreciation or depreciation) is an important measure of performance. You should expect a manager to outperform a money market benchmark with risk (as measured by standard deviation) that is similar to the benchmark. You would expect that risk would be a little greater than the benchmark in order to generate added value over the benchmark. Nevertheless, a conservative, well-diversified strategy with high average credit quality should provide an investor with excess return and limited incremental volatility. Table 4 demonstrates that overall return volatility for the Lipper ultrashort strategy, as measured by standard deviation of returns, has been similar to the benchmark while returns exceeded the benchmark. This exhibit also demonstrates that by taking on additional incremental risk the Lipper short investment-grade strategy had even more excess performance.

Tracking error is another important measure of active risk in excess of a passive benchmark. Tracking error measures the dispersion or volatility of excess returns relative to the benchmark, and therefore, the consistency of a manager’s excess performance. In order to outperform a benchmark, some level of tracking error is expected. A reasonable range for an ultrashort strategy has historically been between 0.60% and 1.00%, while tracking error should increase for a short investment-grade strategy due to its longer (one- to three-year) duration. Tracking error should be viewed over market cycles of three to five years (rather than one-year periods) to gauge a strategy’s risk over longer-term market cycles. The table below reflects tracking error for both strategies over three- and five-year periods.

The Information Ratio is typically viewed as another measure of manager expertise. The ratio is the excess return over the index divided by the tracking error, and it represents the ability of a manager to outperform a benchmark due to manager skill rather than just random chance. The higher the information ratio, the greater the probability that excess returns were due to the skill of the manager. An information ratio of 1.25 represents a 95% probability that a manager has outperformed the benchmark due to manager skill. The table below reflects the information ratio for both strategies over three- and five-year periods.

The lower information ratio for the Lipper short investment-grade strategy represents the cost (or risk) of extra volatility by investing cash in a longer duration strategy.

How to Allocate

Preserving principal is a very important consideration for enhanced cash investors. Consistent with broader asset allocation decisions, an answer will primarily depend on an investor’s holding period for cash and their ability to tolerate principal fluctuation, or risk.

o If an investor holds a portion of her cash for a short time horizon of one or two months and needs maximum liquidity or the ability to redeem an investment at par whenever necessary, she should invest that cash in a money market vehicle.

o If, however, she has a slightly longer holding period–from three months to one year–and seeks to maximize returns while still desiring liquidity close to par, an allocation to an ultrashort strategy may be appropriate. As reflected in Exhibit 5, this strategy remains true to a fundamental focus on principal preservation since it has not experienced a negative quarter during the last five years. Ultrashort strategies have historically preserved principal but yield anywhere from 50 to 100 basis points more than money market funds.

o If an investor’s holding period extends from one to three years, her objective is to maximize returns, and she can tolerate principal volatility, an allocation to short investment-grade may be appropriate. This strategy invests in a broader opportunity set of securities and typically provides a yield cushion over money market of 150 to 250 basis points. Table 6 shows that this yield cushion mitigates against potential principal losses over a slightly longer time horizon.

o If tax avoidance is a priority, she should consider an allocation to tax-exempt money market funds or a Lipper short municipal debt fund. Municipals currently yield as much as taxable alternatives, but the historical relationship is that they usually yield slightly less. Nevertheless, their tax advantages can more than make up the difference, especially for those in high tax brackets.

How far should investors move beyond the money market, and how much should they allocate between the longer benchmarks? The decision should be determined by the holding period for each cash tier, the investor’s ability to tolerate the risk of price volatility, and the tax situation. Finally, do not dismiss allocating among these strategies. A combination of two or all of these strategies, matching different liquidity and risk tolerance tiers of the cash allocation, may be more appropriate than a single strategy in which to deploy a cash allocation.

What if Rates Rise?

Although returns for ultrashort and short investment-grade strategies are positive over long periods, investors may still wonder how they perform in rising interest rate environments. When the economy eventually shows signs of improvement and growth stimulus, there is no denying the potential for short rates to rise.

Two tough years for bonds were 1994 and 1999. During both periods, the U.S. economy was strong and interest rates rose, hurting bond performance. Nevertheless, over each of those periods, the ultrashort, the short investment-grade, and the short municipal debt strategies reported positive performance. The ultrashort strategy had slightly stronger performance as a result of its shorter duration or reduced exposure to interest rate risk. In addition, in periods such as 1994 and 1999 when the economy improved and interest rates increased, municipal strategies exhibited much lower volatility than their taxable counterparts, leading to better tax-adjusted performance. Most importantly, these strategies preserved principal under two rising interest rate environments of differing intensity.

Enhanced cash strategies, whether ultra-short, short investment-grade, and short municipal debt–are not designed to replace money market funds entirely. Rather, they should be used to supplement an investor’s cash allocation to facilitate the pursuit of higher returns over time. Over the past five years, for example, taxable money market funds, as tracked by Lipper, returned 4.16% while ultrashort funds returned 4.74%, and short investment-grade funds 5.49%. This is the kind of difference investors feel in their wallets, especially in the long run.

Americans are clearly parking a significant amount of cash in money market funds to receive technically perfect liquidity. But for long-term cash holdings, an investment in enhanced cash strategies should improve returns. The combination of an expanded investment opportunity set and an ability to exploit the inefficiencies embedded in a steep yield curve allow investors to add value relative to traditional money market funds without subjecting themselves to a significant amount of downside risk.


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