More companies are re-evaluating their investment strategies in light of increased regulations, depleting supply and continued interest-rate compression. What should be your key considerations when establishing a Separately Managed Account?
Separately managed accounts are increasingly viewed as a solution that can provide customization, transparency, yield enhancement, improved risk management, and diversification to a corporate liquidity portfolio. A separately managed account (SMA) is a portfolio of securities, owned by an investor (i.e., corporation) and professionally managed to a set of unique investment guidelines tailored to meet organization needs. In a separately managed account the owner has the ability to customize the strategy by identifying the appropriate maturity profile, sector, currency, and credit risk which are aligned with an organization’s investment policy and liquidity needs. Additionally, the overall strategy may include risk parameters that can lead to better diversification opportunities.
As a global leader in investment banking and capital management, Morgan Stanley provides thought leadership and a broad range of liquidity solutions to its global clients. In a recent interview, iTreasurer asked Robert Leggett, Executive Director, Morgan Stanley Investment Management, to explain the benefits and considerations of creating an SMA as the popularity of this investment solution continues to grow; what’s driving the spike in popularity and what investment managers should consider when implementing an SMA strategy for their organization.
Mr. Leggett says by establishing an SMA, treasurers can develop a highly customized investment strategy consistent with the overriding objectives of principal preservation and liquidity. “Separately managed accounts continue to be a solution considered as a way to offset the changing liquidity landscape and the ongoing low interest rate environment,” he says. “In the US and in Europe, a combination of low yields, changing regulations, and growing cash balances are the primary contributors to the popularity in SMAs, and as the benefits of SMAs are more clearly understood, acceptance has increased and adoption rates continue to move higher.”
Evidence of this popularity has also been demonstrated in recent statistics collected for The NeuGroup’s upcoming Treasury Investment Managers’ Peer Group Summit in May 2016, where there was a notable interest in separately managed accounts among members. According to group statistics, nearly 81% of survey respondents currently have an SMA strategy in place with 85% having created their initial structure more than three years ago. Fifteen percent of respondents have implemented their SMA structures within the past three years and 73% of investment managers say that yield is important or very important when selecting their short-term investment strategies.
Interest in separately managed accounts continues to grow not only because of the advantages they offer but also because of the growth of corporate liquidity. Based on market statistics, at the end of 2015, $2.1 trillion dollars of liquidity was held by non-financial firms in the S&P 500, with over $1.0 trillion held by twenty-five of the largest global MNCs across a variety of sectors, as noted on the chart on the following page.
Regulation and central bank policies are changing the liquidity landscape and it’s important that investors rethink how they have historically managed liquidity. Supply and demand has been affected by Basel III; Solvency II, new collateral requirements, and the presence of low and negative interest-rate policies. It is important that investors realize that liquidity options have changed, according to Mr. Leggett, and that how you have historically managed liquidity will need to evolve. Globally, the competition or demand for assets has become more intense because of the declining supply picture and the arrival of new competitors as banks push deposits off their balance sheets. These forces are unlikely to dissipate soon and as a result liquidity is likely to remain expensive. Solutions, like SMAs, that can provide at least two, if not three, of the primary corporate finance objectives (principal preservation, liquidity, and yield) should be evaluated.
Another key impetus for considering SMAs is the looming MMF regulatory changes set to be implemented later this year. These changes will likely lead to prime and government yields converging as investment managers prepare for the uncertainty of investor behavior and the expectation of continued funds flows away from prime money market funds. In the wake of the upcoming challenges, investors will need to adapt to the new complexities of liquidity investing and take time to evaluate and understand these impacts to their company’s investment portfolio.
“Investors may want to consider alternative liquidity strategies, such as SMAs, which may have substantially the same risk as prime funds; however they eliminate the liquidity fee and gate option,” Mr. Leggett says.
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How Can a Separately Managed Account Help?
There is no one-size-fits-all solution and Mr. Leggett explains that although the goal is to define an optimal portfolio, this definition is specific to each organization and varies based on many factors including the organization’s risk tolerance, accounting and tax considerations, and the ability to accurately forecast cash flows.
The optimal portfolio is likely defined as the strategy that incorporates all the unique considerations of an organization. Mr. Leggett explains, “For example, in Europe many clients are quite focused on the accounting aspects of an SMA strategy because of how it affects leverage calculations. In the US, accounting is also a consideration and depending on the classification can influence the duration target, the asset mix, and how the assets should ultimately be managed. One thing we know is that organizations are dynamic and the definition of what makes an optimal portfolio changes as organizations move through their life cycle or as their liquidity needs change.” One benefit of an SMA strategy is the ability to evolve that strategy as your organization changes or your liquidity needs are revamped.
Being able to forecast liquidity is a critical step before establishing an SMA strategy. Companies that have spent the time segmenting their liquidity have found that the process offers long-term benefits and may allow the organization to adopt an SMA strategy while mitigating funding and liquidity risks. Companies that use SMAs or are contemplating SMAs have spent time enhancing their cash flow forecasting tools which puts them in a better position to evaluate their tactical cash needs and shift the maturity and credit profile to better optimize the balance between principal preservation, liquidity, and yield.
Because liquidity can come at a steep cost, bifurcating your cash may enhance the investment return and provide improved portfolio diversification. According to Mr. Leggett, many clients follow this approach today and often invest excess cash in securities with varied maturities and credit quality to earn incremental returns. “We believe companies that are able to successfully forecast their cash flows are in a much better position to optimize their liquidity which ultimately may lower the cost and increase the return opportunities for their cash”, he said.
Key Considerations for SMA Implementation
Once you have decided to move forward with the implementation of an SMA strategy, it is important to consider these implementation steps to ensure you have a thorough understanding of the implications prior to recommending your new SMA strategy to senior management and the board:
1. Clearly define your firm’s risk expectations. It is necessary to clearly define how much risk you are willing to take and what investment horizon best fits your organization’s cash needs. If your time horizon is medium- to long term or excess cash is available, you may have opportunities to take on incremental risk. Prior to launching an SMA strategy, you should clearly understand how your organization’s key stakeholders view risk and what their expectations are from the strategy. It is important to ensure that your SMA investment strategy is aligned with your firm’s broader strategic objectives and also how a shift toward an SMA strategy may affect debt covenants or credit ratings. Where is your cash located; on- or offshore? Is it trapped or readily available? Do you have plans to repatriate trapped cash, if so, how and when? Take time to clearly define how your organization views risk and get buy-in from senior management before proceeding with the execution of your new SMA strategy.
2. Understand the financial statement impacts of your new SMA strategy. Close collaboration with accounting and tax is critical and the feedback received may influence the ultimate strategy selected. As you build out the suggested investment strategy, it is important to seek the involvement of your accounting colleagues to refine the risk parameters in defining the optimal portfolio. Depending on the tenor of investments and whether the investments will be classified as Held to Maturity (HTM), Available for Sale (AFS), or Trading has implications for earnings per share calculations, balance sheet volatility, financial ratios, credit ratings, potentially funding costs, and ultimately how the portfolio can be managed. This area is extremely important.
Also, the level of financial statement disclosure may shift as your liquidity strategy evolves and you will need to be prepared to develop processes around impairment, fair value pricing, risk assessment and risk disclosure. For example, the chart above highlights the shifting income statement volatility as investments are classified from Trading to AFS to HTM. An HTM classification has a lower volatility impact to the income statement than does a portfolio that is classified as a Trading portfolio. A shift in investment strategy will likely require changes in risk management processes as well as the disclosure of additional information to stakeholders.
3. Evaluate how the rating agencies will view the shift in strategy. Mr. Leggett believes that the rating agencies’ views on liquidity have evolved as cash balances have grown, liquidity strategies have matured, and as the location of cash has shifted. “While it is difficult to speak directly for the rating agencies, we believe that they likely have adjusted their views on liquidity management as corporate strategies have evolved and the visibility into liquidity management has increased,” he says. There is value in having a discussion with the rating agencies to ensure they understand how you are managing liquidity in this evolving environment and to ensure those changes don’t have any unintended consequences for the organization.
4. Evaluate the internal resources available to manage the SMA program. It is important to define your organization’s expectations around how the program will be managed; either internally or outsourced. Depending on this answer, it will be important to identify the existing resources within your organization that will be tasked with managing the SMA. What credit resources will you need and what trading systems will be required? What are the costs of these systems and how does that compare with the cost of outsourcing?
The reporting needs of the new SMA strategy should be calibrated with management and investment committee expectations to ensure that the key risks are identified, monitored and reported as necessary. Leveraging your investment manager is important but also recognize that there are organizations, like Clearwater Advisors, who provide broad reporting and risk management solutions to corporate clients.
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Benefits Far Outweigh Challenges Based on input from NeuGroup TIMPG members, top benefits of having an SMA strategy include:
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 Robert Leggett |
So, is it Worth the Effort?
The challenges of carving out the initial time to develop the SMA strategy and educate senior management and the board of directors on the merits of the strategy can be time-consuming, but based on input from TIMPG members, the benefit of having an SMA program far outweigh the initial challenges of implementing this type of strategy. As regulatory impacts increase and the residual effects of depleting supply along with the continuation of near-zero interest rates place pressure on investment managers, corporations are encouraged to evaluate separately managed accounts as a way to offset some of these challenges.