One of the (many) headaches of the current financial market setup is the lack of return on cash or term deposits that can hold onto the real value of money. This is a modest but important ask. Many investors want an unreasonably large liquidity pool that will have no risk of capital loss well beyond their short-term requirements. In the ideal world that changes, in reality, it has to be managed.
For a manager of low-return income assets, the critical issue is redemptions, flows and market pricing.
The approach to low-drawdown, daily-liquid strategies is typically anchored with a major weight in public-market investment-grade credit. As we well know, the blowout in spreads in March last year resulted in negative returns at that time. Those that did not show any loss, usually had a large allocation to private credit or other instruments that are not marked-to-market. Whether they are truly capable of daily liquidity if they were to be subject to withdrawals has yet to be tested.
The irony is that funds that avoided public market pressure were less likely to see redemptions, while those that priced to market conditions often did.
For the moment, let us assume conditions are relatively stable. Investment-grade credit can eke out around 2%–2.5% gross return. After fund fees and advisor fees, the return to the investor is likely to be closer to 1%. That’s a tough proposition to sell.
Funds have some options to lift returns and, just as importantly, reduce the risk of spread widening. The most obvious is active management of credit, be that tenor or relative value. Other options can include widening the active mandate to move between private and public credit while retaining a high enough weight in public markets to ensure liquidity. A perfectly sensible approach is to offer monthly liquidity.
Most investors had no quibble with three-month or even six-month term deposits, yet shirk away from funds that have such timeframes. The alternative of imposing a buy/sell spread goes down like a lead balloon.
To lift the gross return to an acceptable 3%–4% (implying net return of around 2.5%) does require the fund to consider adapting the portfolio. Some may trade more frequently or bank basis-point returns from new issues, a potentially costly high-trading strategy. Others may be able to use credit default swaps to avoid spread widening, not an easy assignment.
A left-field idea is to have a very small position in equity puts, which pay off when financial distress is transmitted to credit. Others finesse their risk budget and take on high-yield credit if modelling can show that it is safe to do so. Currency pairs are another option. Liquidity can sit in semi-government bonds, which are not a source of great return, but one better than cash.
The question is whether advisors are prepared to put in the work for such low-return options. Yet in a world with low rates for a long time, and an uncomfortable correlation in risk, a low-volatility fixed income strategy still has a role. Then there is the issue of fees. Fund fees have to be low, say 30bps, and there may have to be the option for an advisor to carve-out these investments from the usual advice fee akin to not charging to cash. This may engender goodwill that is returned when that liquidity bucket is required. Advisor fees on an all-encompassing portfolio may outlive the increasing diversity and requirements of their investors.