The Rule of Cash Investing: Diversification

If the mantra in real estate investing is location, location, location, then the rule of cash investing is diversification, diversification, diversification. The importance of this discipline can be seen in lessons found in the Auction Rate Securities market, certain banking sectors and in selected geographic credit exposures where either liquidity or credit issues can become a concern for overly concentrated investors. Higher return is almost always the lure that leads to portfolio concentration issues and these securities can sometimes be cloaked behind high ratings and/or strong brand names.

The practice of applying concentration limits per issuer, sector and asset class can often be used to avoid inappropriate exposures driven by a desire for yield. Separate account cash investment strategies, often managed with a customized investment policy, tend to mandate diversification. Conversely, one may find greater concentration risk develop in bank deposit products and/or managed money market funds. For instance, the new 2a-7 guidelines governing money market funds limit single issuer concentrations by Tier 1 and Tier 2 ratings, but offer little diversification guidance beyond that. Because of this, exposure to a large number of financial issuers – some weaker than others – may still be found in portfolios as managers seek yield opportunities and take advantage of their investment latitude. Our recently published white paper explored the varying degrees of European finance exposure in prime money market funds.

On the other hand, due to the uncertainty of cash flows inherent in pooled investment vehicles, the 2a-7 guidelines generally have significantly more restrictive duration limits than what may be found in separate account cash investment policies. While we believe money market fund managers do a thorough job of mitigating risk given the latitude they have, we would recommend investors understand the differences between an investment policy they would create for their own treasury practices versus a policy that governs a money market fund.

Concentration limits should also be considered for Bank MMDA exposure as federal guarantees have either expired or don’t apply in all circumstances. Banks may set alluring rates on the MMDAs to attract deposits, but prudent cash investors understand the credit exposure, in the end, reverts to a bank’s portfolio.

Treasurers may be enticed by yield opportunities found through attractive bank deposit schemes or the “sort by yield” features available with money fund portals; however, we believe concentration limits in formal investment policies and discipline in applying the limits to all cash pools can help avoid the pitfalls of the past while prudently pursuing yield.

In this month’s Research Spotlight we’re taking a look at diversification as a tool in portfolio construction against a backdrop of various yield opportunities and products, which may provide some enticing options. However, while there’s always temptation to seek yield in a cash portfolio, we would warn against increasing concentration risk in the process.

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Best Regards,

Ben Campbell
President & CEO