Enhanced cash strategies grow popular with institutional investors

Interest in enhanced cash strategies has returned, despite major upheaval during the global financial crisis. But this time, managers are warning clients to be careful.

“To me, this is one of the interesting lessons we haven't learned from the global financial crisis,” said Barry F.X. Smith, senior managing director and global head of State Street Global Advisors' cash business, Boston. "This has to be a risk-appetite discussion.”

Flows into these strategies have been “fairly dramatic” in the past 18 months, as investors have fled near-zero returns from the safest cash investments, said Paul W. Reisz, senior vice president and product manager at Pacific Investment Management Co, Newport Beach, Calif. Enhanced cash assets in the U.S. market — which halved in 2009 to $16 billion from a year earlier — reached about $40 billion as of June 30, Mr. Reisz said.

Earlier this month, the $913 million Chicago Firemen's Annuity & Benefit Fund began a search for a global enhanced cash/short-term bond to run $20 million. And the 470 billion Danish kroner ($87 billion) ATP, Hilleroed, Denmark, uses a broad range of cash investments to achieve the highest risk/reward profile (Pensions & Investments, Oct. 17).

Investors employing enhanced cash strategies often do so using a tiered system, reserving the safest — and therefore lowest returning — money market strategies for their immediate cash needs, then opening up cash held for longer periods for strategies that add a bit more duration and/or credit risk.

But those were precisely the types of cash strategies that burned investors in the global financial crisis. “People focused on the enhanced returns but didn't think about the enhanced risks,” SSgA's Mr. Smith said.

PIMCO's Mr. Reisz agreed, advising cash investors “don't forget about what happened before; check under the hood.”

Mr. Reisz expects enhanced cash strategies will see continued inflows, as there's no relief to low interest rates in sight. Also, pending regulatory changes in the U.S. and Europe could further compress yields on the safest cash instruments, as could the expiration of the Federal Deposit Insurance Corp.'s unlimited coverage guarantee on non-interest-bearing transaction accounts. On Dec. 31, the limit returns to the normal level of $250,000, leaving $1.5 trillion in cash deposits looking for a new home, he said.

He suggests one way for investors to be able to get full daily transparency on a manager's enhanced cash holdings is through exchange-traded funds.

PIMCO has partnered with ETF provider Source UK Services Ltd. to create actively managed ETFs for European investors based on the PIMCO Enhanced Short Maturity strategy. ETFs allow investors to check holdings daily, giving them a look “under the hood,” Mr. Reisz said.

Source's ETFs based on PIMCO's enhanced cash strategy are based in U.S. dollars, euros and pounds sterling, and have gathered about $200 million to date. “We'll see those funds continue to grow over time” as investors are driven out of money market strategies in search of higher yields, said James Finch, executive director and head of the U.K. and Ireland at Source, London.

In Europe, most money market funds have shut the doors on new clients as the market for securities with yields above zero has dwindled. SSgA's Mr. Smith said institutional clients have found liquidity elsewhere in order to hold their places in money market funds, and have taken to either buying short-duration securities directly or depositing cash in bank accounts.

In the U.K., pension funds — especially those using liability-driven investment strategies that employ derivatives — have begun hunting for higher yields in their strategic cash portfolios, said Peter Halligan, investment consultant and cash specialist at investment consultant Aon Hewitt in London. However, British pension funds have gotten creative in boosting yields in cash. Instead of using enhanced cash strategies, they've put parts of their cash portfolios into absolute-return bond strategies and diversified growth funds that use a benchmark tied to cash rates. Both strategies have downside protection and can have better risk/return profiles than enhanced cash strategies while matching the liabilities of floating-rate swap payments, Mr. Halligan said.

“There's always been a different appetite for risk among these investors,” especially for those needing to close funding gaps in their pension funds, Mr. Halligan said.