Cashing In

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.