“Things which hurt, instruct.”
-Benjamin Franklin
It is a rare historical event when a credit-crunch induced financial market setback seeps its way into the conservative backwater of cash management. Yet that is exactly what has occurred during the volatile summer months of 2007. Rather than enjoying its usual role as the “safe-haven” during times of market stress, the cash component of managed futures and hedge fund portfolios has undergone a heightened level of scrutiny and alarm usually reserved for far riskier segments of the financial markets. Is this attention and concern warranted? I would argue that properly defined and rigorously executed, the realm of cash management is not only rock solid, but currently an extremely attractive asset class.
First, it is imperative to clearly define the role that cash management should play for fund managers, who by the nature of utilizing levered exchange-traded futures contracts, maintains large offsetting margin (i.e., cash) balances on their books. An effective cash management strategy is more than the simple function of sweeping bank balances to an overnight investment account. Correctly set up and executed, a cash management strategy must accomplish three critical goals: the preservation of capital, the efficient use of capital and the prompt movement of capital. Recent painful events, such as the implosion of Sentinel Management Group, along with the less well understood temporary seizing up of a large component of the commercial paper market, have provided the perfect case studies as to how best understand and achieve these three goals.
Preservation of Capital:
“Two rules: 1. Preserve the principal. 2. When in doubt see Rule 1.”
- Warren Buffett
Although seemingly obvious, this continues to be the first area where futures fund managers can get off track. The object here is quite simple: achieve a fair and low-volatility investment return on cash that is superior to simply holding overly safe treasury bills. The key misstep to avoid is chasing above market yields that inevitably get exposed by the old bromide: “If it seems too good to be true, it usually is.” However, there are significant elements of a cash management strategy that fund managers CAN control to avoid falling into this trap:
Separately managed accounts: Managed futures and hedge funds that display no discernable cash flow patterns are best served by an investment strategy crafted around unique and individually managed accounts, and not in a pooled account. When fund cash assets are commingled in a pooled vehicle, holders are exposed to large withdrawals of other investors, and to the subversion of individual crafted risk tolerances to the less well-defined “greater good.” Work with an investment manager who will craft a unique cash portfolio solution tailored specifically to your risk tolerances and liquidity requirements.
Limiting security selection: A fund’s cash balances are not to be treated as an isolated separate investment strategy. The goal is to achieve absolute positive returns over a chosen benchmark (e.g. Treasury bills), not relative returns versus other asset classes. Bank Leveraged Loan funds, Floating Rate Mortgage funds and Enhanced Libor funds (to name just a few) are higher volatility bond funds masquerading as cash alternatives — despite their use of descriptors like “low volatility,” “enhanced cash,” or “daily liquidity.” Those vehicles are bond sector investment choices and not cash substitutes. Stick with plain vanilla, high-quality and highly liquid securities (i.e., a maximum maturity of any single component of two years) in a diversified strategy crafted by a dedicated cash management firm. Moreover, in a positively sloped yield curve environment, or during a period of generally falling interest rates, this also will provide a higher yielding solution than sole reliance on off-the- shelf money market funds, which are restricted by law to keeping all individual security purchases to 13- month maturities or shorter.
Transparency of client account statements: The integrity of a funds’ cash account is sacrosanct as long a two key tenets are met: transparency with easily referenced listings of holdings provided via a daily account statement, and the ability to independently verify holdings by having direct access to the custodial banks’ record keeping systems. Case in point: If Sentinel clients had the ability to access their account information directly from Bank of New York, it would have been virtually impossible to hide the rapidly deteriorating nature of the underlying investment strategy. It would (or should) have revealed notations as to the loans, reverse repos and pledged collateral, all flagging Sentinel’s unauthorized use of leverage to juice returns.
Capital Efficiency:
“Money is better than poverty, if only for financial reasons.”
- Woody Allen
Fund managers are increasingly aware of the need to make all their assets work hard, including cash. Even the Managed Funds Association (MFA) endorsed this approach in their 2005 Sound Practices for Hedge Fund Managers publication, stating in bold print in Section IV-5: “Cash should be actively managed.” It is no longer good enough to view cash management as an administrative chore. As fund returns compress in an increasingly competitive and volatile financial market environment, these very same fund sponsors are looking to enhance the efficiency of their underlying capital pool by moving to a more market based approach to cash management rather than solely rely on passive strategies like bank deposits or below market interest rates offered by their futures commission merchants (FCM) or clearing firms.
At the end of the day, cash management is essentially a spread business — earning a conservative net margin over the managers’s cost of funds (i.e., benchmark). Rather than passively giving that spread away to competing financial intermediaries (e.g., prime brokers and clearing firms), fund managers are increasingly hiring fee based investment advisors to structure a customized cash solution. This allows the fund manager to capture that spread to the net benefit of their own underlying investors.
Movement of Capital:
“Beware of little expenses; a small leak will sink a great ship.”
-Benjamin Franklin
By centralizing all movement of monies and related record keeping under one cash management umbrella, fund managers are able to be highly efficient in the production of internal reports and investor statements. Moreover, this centralization process should produce a savings of bank related fees and a maximization of investable excess cash. This latter point is of particular importance during current periods of attractive 5% plus yields being generated by the cash management portfolio. Sweeping excess margin balances from exchanges, clearing firms and FCM’s is both a prudent risk management strategy and a potential source for enhanced fund performance based on the spread game described above. Above all else, centralizing money movements allows the fund manager to focus their own efforts on what they do best: executing the core investment strategy of their fund(s).
Contrary to the ‘sky is falling’ media-driven frenzy about reputed problems in the commercial paper markets, a balanced and well-run cash management strategy remains an oasis in today’s choppy market environment. At its core, cash management is — and always should be — a boring business. Yet at the same time, it provides many compelling ancillary benefits for fund sponsors around the generalized themes of liquidity and efficiency. Following the core principles outlined above will help you avoid unpleasant surprises.
Bob von Halle is managing partner of Horizon Cash Management. He can be reached at bobvh@horizoncash.com.
