When onboarding new clients, we typically have the opportunity to review work previously done by consulting firms who worked with the client before us. I’m always astonished to see the frequency that cash positions were neglected and not reviewed, or if they were reviewed, the casual nature of the review. Most of the previous consultants focused on yield (return) alone without adequately addressing the tradeoffs that can generate yield, even when those tradeoffs are material.
For cash equivalent (money market, stable value, fixed annuity) products, there are three items that will allow for higher yields: duration, liquidity, and quality. Any competent review of cash products must, at a minimum, control for these three factors.
Duration. For cash products, the duration of the fixed income securities used to populate the portfolios should materially impact yield. Fixed income securities with longer durations (holding periods) generate higher returns than products with shorter durations. For example, think of a typical CD at a bank, three-year CDs have higher yields than three-month CDs. The risk of yield lies in the rising rate environments (like the one we’ve experienced in recent months) negatively impacting the value of longer duration securities more than shorter duration securities. As a result, cash equivalent positions with longer durations may have to decrease yield as interest rates rise.
Liquidity. One of the primary attributes of money market investments is that the cash is available to investors immediately. Money can be added or withdrawn at any time. Frequently, stable value and fixed annuity positions restrict participant and plan sponsor liquidity. Restricting liquidity controls cash flows, and allows portfolio manager longer time horizons with which to invest and thereby accept more risk. However, the yield liquidity restricted products can generate is often offset by those limitations. Participants fail to understand liquidity restrictions until they are prohibited from acting in their accounts, and plan sponsors only pay the price of liquidity when they want to make a change in providers of investment portfolios.
Quality. Rational investors only buy more speculative investments when they are rewarded for those investments with higher expected returns. The trade-off being the higher return in exchange for the possibility the investment doesn’t produce the expected return. One way for cash managers to increase return is to purchase more speculative fixed income securities with the cash. While some may fail to produce, in aggregate the returns of all securities should be higher.
One of the substantial changes to money market regulations in 2016 was to reduce the degree to which money market funds could reduce the quality of their holdings. However, fixed annuity and stable value portfolios frequently use quality as a method to supplement yield.
In comparing products looking at yield alone, without controlling for these factors, will result in the potential for bad decisions, or at minimum, uninformed ones.
In the wake of changes in money market regulations in 2016, we delivered a presentation that addressed the changes and the status of the cash equivalent marketplace. Given the current rising rate environment, now may be a good time to review that topic again.
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