Benchmark Selection for Cash Portfolios

Corporate treasury managers are frequently confronted with the task of picking the right benchmarks for their cash portfolios. Unlike stocks and long bonds, a market-based index is often too long or too risky for cash investments. Some treasurers resort to comparing “yield” earned on investments on the assumption that it is the only relevant factor in a “buy-and-hold” strategy. We want to offer our take on choosing appropriate benchmarks for corporate cash portfolios.

The Need for Benchmarking

Some argue that, if a cash investor’s main objective is to maximize yield, having a benchmark is irrelevant. Within reasonable risk parameters, the higher the yield, the better. Why, then, is there a need for benchmarking?
A benchmark is the yardstick to direct an investment strategy and to measure the success of this strategy. Its usefulness lies in its representation of a “neutral” position for the investor with matched investment horizon, risk tolerance, liquidity needs and return objectives with its investment policy. In addition to being a measurement of manager performance, the benchmark is frequently used to simulate interest rate scenarios and to analyze trading and opportunity costs. Even though a perfect benchmark may not exist for a given cash portfolio, adopting one provides a good starting point for the cash manager to understand return attributions.

Golden Rules of A Good Benchmark

An appropriate benchmark, according to the securities industry trade group CFA Institute, is a recognized published index, a tailored composite of assets or indexes, or a peer group of similar funds or portfolios. Good benchmarks generally share the following common characteristics:

• They are objective and investible
• They are representative of the asset classes
• They represent comparable risk levels to a policy mandate
• They are developed from publicly available information

Common Types of Cash Benchmarks

Peer Group Averages: Also known as the “horserace” method, this is a commonly used method of measuring returns against that of a large universe of mutual funds with similar investment objectives and styles. For cash portfolios, the Lipper Institutional Money Market Fund Average provides average performance of all eligible institutional class money funds.
The Lipper Average may be an appropriate benchmark for hold-to-maturity investors of very high quality investments with short average maturities. According to SEC rule 2a-7, money funds must have a security maturity limit of 397 days and average maturity no more than 90 days. Money funds are allowed to use the “amortized cost”, or book value, method to compute returns. The investment grade requirement also makes the average credit quality comparable to most buy-and-hold cash investors. Besides Lipper, the Money Market Report Averages published by iMoneyNet offer a similar peer group benchmark for money market accounts.
A major drawback of the peer group method is the big maturity gap between the money market universe, which may be 45 days long, and the short-duration bond universe, which can be as long as two years. Peer group comparison is also a net-of-fees return that makes it difficult to discern whether a strong number is the result of a manager’s investment skills or due to a lower fee structure.
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