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Talking Point - Cash management

Just as weak markets have pushed investors towards cash, traditional cash options such as savings accounts look less safe than ever before. Nevertheless, as we know, a cash cushion is an essential part of any balanced portfolio, whether it is held for tactical reasons, for short-term spending or for emergencies.

Furthermore, while returns on cash may be low compared to the potential returns on equities from these levels, an additional 1% to 2% return per year on cash holdings can add up over the longer term, so it is worth shopping around for the right cash product. So what are the options?

Although cash may have proved a very sound place to have had money in 2007 and 2008, in the long term a large cash position is a risky strategy. With the exception of the last 10 years, it has historically underperformed both equities and bonds over ten years plus and, unless it is specifically index-linked, might not protect against inflation. The result is that those with large cash holdings can tend to see their buying power eroded over time.

Also, while maintaining a large cash position in difficult markets is seductive, this can also mean investors miss the bounce in equity or bond markets when it eventually comes. Market timing is notoriously difficult and looking to move in and out of markets can be a quick way to lose money. Many top-performing days in the stockmarket come immediately after a big slump in share prices and missing out on those days can dent long-term returns.

However, a balanced portfolio needs an allocation to cash. The general recommendation is for people to hold three months’ salary in readily available cash. Traditional savings accounts have been a preferred route but, although there are still some high headline rates available, investors need to check the small print – for example, penalties for the early withdrawal of cash or for not investing a certain minimum amount at regular intervals. Interest rates can also vary significantly and initial rates are often not sustained.

The main risk – certainly at the moment – however, is that, if investors are exposed to just one bank and if that bank runs into solvency issues, they could lose some of it. In the current climate, the credit quality of the bank should be a higher priority for savers than a high headline rate and investors should be spreading any savings over £50,000 across more than one institution to make the most of the Investors Compensation Scheme arrangements.

Money Market funds

Money market funds are of course another option for cash holdings. These will hold a variety of short-term cash or near-cash instruments from different institutions so, should one company goes bust, it should have minimal impact on the portfolio. The returns are generally linked to or targeted on Libor – the standard inter-bank lending rate – rather than the Bank of England base rate. This has proved an advantage over the past year, when Libor has been significantly higher than the base rate, though this is not guaranteed and may normalise as the credit situation improves.

Money market funds are largely commoditised as the rules governing AAA-ratings are tight. They are likely to be constructed with around one-third of assets in overnight holdings for liquidity. These instruments will be bank deposits or repurchase agreements – ‘repos’, which act like a secured loan. The remainder will be in longer-term debt instruments, such as floating rate notes, certificates of deposit, commercial paper or asset-backed commercial paper, though in practice all will generally have a duration of less than 12 months.

The aim is to build a portfolio based on security and liquidity, rather than high performance. Indeed, performance varies little between money market funds with figures from Morningstar showing that, except in extreme cases, less than one percentage point separates the majority of funds in the sector.

Exchange-traded funds

Cash exchange-trade funds (ETFs) are relatively new to the UK marketplace and so, for the time being, choice remains limited. However, they do offer an alternative cash option for investors. These ETFs aim to match a particular cash rate such as overnight deposits or the 30-day rate.

To achieve this, they buy a basket of investment grade bonds, which also acts as collateral. The rate is guaranteed by a bank. Cash ETFs are, like other ETFs, cheap and liquid -  not to mention gaining in popularity. One provider, Lyxor Asset Management, recently reported a 326% increase in cash ETFs over the course of 2008.

UK Government Gilts

High-quality, short-term government debt has also traditionally been seen as a safe home for cash holdings - on the assumption that developed economies would not go bust. However, the current situation may have raised questions about the UK Government's position and some fear that the large amount of borrowing employed to shore up the UK and US economies will dent the creditworthiness of their debt. Rumour has it that the UK might lose its AAA-rating.

In reality, of course, the likelihood of a developed nation going bankrupt is low, but government bonds already carry a risk of capital loss if not held to maturity - as we know, interest rate changes affect their capital value day to day. There has also been a long bull run in government bonds as investors and pension funds have sought to shore up their capital positions and find an alternative safe haven in the volatility - so government bonds do look expensive and make this erosion of capital a perhaps even greater risk.

Cash account availability

A number of the platform providers now have attractive cash rates on offer and these may be standalone or connected to a wrapper such as an ISA or SIPP. For example, FundsNetwork offers a ‘cash park’ account, where investors can put cash into an equity Isa and be paid interest while deciding where and when to invest in the equity market.

Ultimately the cash part of a client’s portfolio needs to be as predictable and risk-free as possible. The current environment has exposed the potential pitfalls for cash holdings and underlined that cash is not simply cash – returns and risks can vary significantly from product to product. Investors and their advisers have plenty of options beyond a standard current account – so be sure you have gone through all of the risks and help them keep their savings as safe as possible.

Pearson Hinchliffe Financial Services | Hollinwood Business Centre, Albert Street, Hollinwood, Gtr Manchester, OL8 3QL
Telephone: +44 (0)161 785 3500, Fax: +44 (0)161 624 2589, Email: enquiries@pearson-hinchliffe.co.uk