Three Degrees of Liquidity
by Jason Singer, Managing Director, Head of International Cash Portfolio Management, Goldman Sachs Asset Management
Liquidity management has always been an important consideration for treasurers, but the recent credit crisis has forced them to review their investment policies and ensure their company’s cash is managed within the boundaries of an effective and well-balanced risk management framework.
The recent focus has been on remaining highly liquid with the result that companies are holding more cash than previously. Treasurers must decide how to manage cash effectively whilst ensuring it is safe, available when required and makes a competitive return for the company while minimising market and credit risks.
As economic confidence returns, capital security and access to cash still remain critical – however, treasurers may be beginning to either give up liquidity, or extend duration in the search for higher yields. Before considering the re-introduction of riskier assets, we recommend that treasurers partition their cash reserves into portfolios with distinct functions, time horizons and investment objectives. We believe that this process can help treasurers find a more stable balance between return, risk and liquidity.
At Goldman Sachs Asset Management, we divide liquidity into three categories: primary, secondary and tertiary. This is because every corporate’s cash management structure is different and we like to understand how cash holdings break down based on factors such as their cash flow volatility and investment horizon. For example, primary liquidity means there is high cash volatility and therefore a short investment horizon (i.e., day-to-day, a week or a month). Secondary liquidity is where cash flow volatility is relatively low and so the corporate has a longer investment horizon, i.e. between six and 12 months. Some corporates will have what we define as tertiary liquidity which refers to a long-term, strategic cash holding where there is very little or no cash flow volatility; for example the investment horizon could be 12 months or longer.
Corporate treasurers should therefore seek investments which match their investment horizon, risk tolerance and cash flow considerations. A treasurer can decide where on the risk-return spectrum their treasury policy enables them to invest; when the funds are likely to be required and how quickly. In addition, they should look at how much risk the company is prepared to take and how much income volatility they consider appropriate during the period of investment.
Generally speaking, primary liquidity investments would seek money market fund-type returns. Money market funds (MMFs) are now increasingly accepted as being cash equivalents, and are generally interchangeable with cash deposits from an accounting and capital adequacy standpoint. In addition to their security and liquidity, as pooled investment vehicles, money market funds can also bring the benefits of inherent diversification. The use of money market funds also essentially outsources some of the more complex investment decision-making and credit analysis requirements. At Goldman Sachs Asset Management, for instance, we have access to more than 245 Goldman Sachs & Co credit analysts who provide independent analysis of all short-term trades, which we consider provides an extra tier of client protection.
When selecting money market investments, we believe investors should be aware of money market funds’ main objectives, along with the provider’s credit review, security selection and risk management capabilities. Our investment policy and philosophy has not changed in the 28 years we have been managing money market assets. We remain committed to our conservative approach, focusing on effectively managing portfolios by preserving capital and maintaining a high degree of liquidity.
As corporates have become comfortable with MMFs, some are now considering other options available to them, such as Libor-generating strategies. Corporates may want a product that will give them a better return on their cash and they may be willing to compromise some liquidity to achieve that goal. They need to understand the implications associated with a longer investment horizon. Each corporate will need to determine the level of risk with which it is comfortable individually, as quantifying risk becomes different when you move into the secondary and tertiary liquidity categories. One of the best ways of gaining greater understanding is to speak to asset management partners who will be very happy to spend some time providing educational sessions.
Reviewing and improving a company’s risk management policies should not be a one-off project; while many treasurers will have reviewed and documented their investment policies and procedures, unfolding market events and evolving technology should prompt treasurers to review their policies on a regular basis. Today, with higher surplus cash positions, primary, secondary and tertiary liquidity becomes more relevant, as corporates start to think about how to make their cash work harder. As some treasurers move their cash into longer-term investment horizons, such as Libor-generating products, we believe that the use of MMFs for their short-term investment strategy continues to be compelling.