By Lance Pan, Capital Advisors
Tired of the uncertainty of money market funds? Separately managed accounts offer a logical complement to money market fund solutions.
For corporate treasurers there were no shortage of lessons learned during financial crisis. One sharp lesson was that, despite their apparent safety and liquidity, pooled investment vehicles—like money market funds—are susceptible to lapses in investor confidence. Although it may take a change to the company’s investment parameters, there are alternatives. One is to use separately managed accounts.
Whether to use a commingled asset pool like a money market fund or an investment manager in a separate-account format is an age-old debate for corporate cash investors. Few would dispute the benefits of a constant $1 share price and the daily liquidity offered by a money market fund; however, a separate account investor with specific investment guidelines might have avoided the collateral damage and anxiety from some of the poorly conceived investment strategies in commingled vehicles.
In the area of corporate cash management, the use of SMAs has a long tradition, but a limited following. According to the 2011 survey by the Association for Financial Professionals, approximately 19 percent of US corporations permit separate account investing. This compares to 62 percent that allow money market funds and another 16 percent allowed in other forms of commingled vehicles. Figure 1 below shows the percentage for money market funds has been declining steadily since 2009, while the permissible use of SMAs has been climbing.
Recent credit, yield and regulatory trends may have affected this transition. While we believe SMAs help improve transparency and oversight, their potential advantages do not stop at risk management.
MMFs Remain Embattled
Despite a small victory in August when Securities and Exchange Commission Chairman Mary Schapiro cancelled a vote on new rules to govern the $2.7tn MMF market, the industry remains girded for battle.
That’s because in the month or so since, Treasury Secretary Timothy Geithner weighed in, urging members of the Financial Stability Oversight Council to consider new rules. In a letter to the FSOC, Mr. Geithner suggested that while the SEC is “best positioned to implement reforms” to address MMF risks, the Council and its members “should, in parallel, take active steps in the event the SEC is unwilling to act in a timely and effective manner.”
Add to this the news that one SEC commissioner who said he would vote against new MMF measures now says he would support at least one—a floating NAV. So the anti-MMF forces are gathering once again; while the make-up of SEC voters still supports no change, treasurers should be thinking about alternatives.
Customization Advantages
Many of the potential and obvious advantages of SMAs reflect its traits of individuality. As assets and investment preferences are not commingled with those of others, individual investors are able to work with their investment manager to customize investment strategies and construct a portfolio catering to their own risk tolerances, return expectations and specific operating cash needs.
1. Tailored Risk Management. Every investor faces unique circumstances that impact income, growth, safety and liquidity considerations. Understandably, a commingled vehicle rarely satisfies the preferences of all investors in a fund. In a separate account relationship, an investor may set specific guidelines on some of the key risk control metrics such as maturities, concentration limits, ratings and liquidity requirements.
Also an effective risk control mechanism may be a list of prohibited transactions including the use of financial leverage, derivatives and/or specific security types to be excluded.
2. Transparency. Another potential advantage related to risk control is the level of disclosure of investment activities for SMAs. In addition to periodic statements, reports and expenses, an investor is entitled to all relevant portfolio information on demand.
Equipped with the right data, the investor may address and deal with credit issues in a relatively timely fashion. Conversely, money market funds release information on a monthly basis with several days of lag time.
3. Higher Return Potential. When comparing and contrasting commingled and separate account investments, one cannot stress enough the potential return aspect. Under certain conditions, a separate account may provide higher yield potential than a typical money-market fund. There are two reasons that may contribute to this.
a) Exemption from Rule 2a-7: The governing SEC regulation for money funds includes Rule 2a-7 which limits investments to well-diversified short-term securities with high credit ratings. The revised rule, in place since 2010, further restricts liquidity and maturities and reduces yield potential. As such funds make up a major part of the short-term credit market, securities not eligible for the 2a-7 parameters, such as those with maturities slightly longer than 13 months, may be less popular and subsequently higher-yielding.
A separate account may avoid some of these pitfalls and achieve higher income potential by adhering to measured parameters beyond 2a-7 without violating the investor’s risk tolerance.
b) Yield curve positioning: Another higher yield potential for separate accounts is related to the levels of interest rates. Generally speaking, investors may expect investments with longer maturities to outperform money market funds in a stable interest rate environment.
When the levels of interest rates are relatively stable, there is a general belief among investors that the higher risk of longer-term securities demands higher yield to compensate for owning such securities. The Federal Reserve’s commitment to hold rates at “exceptionally low” levels for at least the next three years may provide an opportunity for separate accounts to outperform.
4. Free from “Hot Money.” One of the difficult realities a commingled fund manager faces is the movement of “hot money” from fund to fund by certain investors to take advantage of favorable yield. The constant $1 share price and the convenience of daily liquidity make money market funds the obvious targets that present serious challenges to fund managers. Volatile cash flows can force managers to either leave too much idle cash in the portfolio or to sell securities at a loss to satisfy redemptions, both of which may have serious long-term implications on fund performance.
On the other hand, separate account investing is not affected by cash flows from other investors. SMA investors can and often do work with managers in response to upcoming cash flow changes weeks or months ahead. Such information becomes a valuable tool in helping to improve the account’s investment performance.
5. Income & Capital Gains Management. Practically speaking, few corporate cash management accounts focus on total return initiatives. Instead, most focus on income potential and accounting gains. The advantage of a separate account that allows an investor to work with an investment manager on certain yield targets, income recognition and capital gain/loss management, cannot be overstated. This is especially true for some publicly traded companies where investment income is a meaningful contributor to the firms’ bottom lines.
Income forecasting, gains recognition and loss-harboring for tax purposes are some of the tools unavailable from commingled vehicles.
6. Versatile Reporting. In addition to risk and return considerations, the separate account setup allows an investor to receive customized reporting unavailable from commingled vehicles. For investors concerned with performance measurement, corporate governance, audit oversight and operational efficiency, the number and details of reports are limited only by the investor’s preferences and the manager’s technological capabilities. Compliance reports that detail all portfolio activities and current holdings may be included among these reports.
The process one goes through to establish a separate account relationship may take more steps than a mere mouse click on a fund portal, but investments in time and research may bring just rewards during times of uncertainty.
Lance Pan is Director of Investment Research & Strategy at Capital Advisors. He can be reached at +1-617-630-8100 or [email protected]