In August 2016 something peculiar occurred in the world of Irish finance. Bank of Ireland, the largest lender in the country, announced that from October it would begin charging certain corporate customers 0.4% to hold their cash overnight.
That’s right – some companies must now pay for the privilege of handing their money over to the bank. And Bank of Ireland is not alone in tearing up the traditional banking rule book. Within the Irish market, Ulster Bank has also commenced charging negative interest rates for a small number of large corporate clients. Further afield, ratings agency Fitch estimated that at the end of 2016 there was $9.3 trillion of negative yielding debt worldwide. While individuals and small and medium-sized enterprises (SMEs) are unlikely to face the prospect of paying banks to hold their money, they are equally unlikely to see any meaningful returns on their deposits for the foreseeable future due to historically low rates.
Yogi Berra, the All-Star American baseball player and highly-quotable Yankees legend, once commented that “in theory there is no difference between theory and practice. In practice there is”. Perhaps Yogi would have been less surprised than present-day economists by the current financial environment. It had long been widely assumed that the lower bound interest rate could not fall below zero; after all why would anyone pay someone to hold their money when they can merely stick it under the mattress instead? Yet that is precisely the situation financial institutions and certain corporates find themselves in. The European Central Bank along with the central banks of Denmark, Japan, Sweden and Switzerland have all placed a charge on financial institutions’ excess funds that are held on deposit at the central banks. As these rates act as a benchmark for a wide variety of fixed income instruments, SMEs now find themselves earning a pittance on any funds held on deposit.
Yield on 10-year government bonds, 1995-2016
This unlikely scenario can be traced back to the financial crisis that began in 2007. In an attempt to revive growth in a lagging global economy, central banks reduced their benchmark rates to below zero in order to make spending more attractive and saving less attractive. It was hoped that this would spur lending and thus boost economic activity at a time when people were left scarred by the greatest economic downturn since the Great Depression of 1929. While the benefits of this unorthodox monetary policy remain open to debate, it is clear that we now live in a very strange financial environment, where companies sitting on excess cash reserves can expect little or no return if they merely park it in the bank.
A company has multiple uses for the capital it holds on its balance sheet. Some may be earmarked as emergency reserves, while portions may also be held for the purposes of M&A (merger & acquisition) expenditure. Some companies may be in the enviable position of having surplus cash that can ultimately be used for extraction. Traditionally these reserves would be held on bank deposit, with interest earned off-setting the cost of short-term debt facilities. This dynamic is now broken, and corporates are searching for alternatives.
If companies want to generate an adequate return on surplus cash, one would think there is a wide range of feasible options to choose from. If only.
The traditional option of depositing cash in a bank account isn’t overly enticing. What about high-quality bonds? Historically, they have been popular among pension funds and other risk-averse investors due to their perceived safety. Today a blended mix of 0-3 year bonds can expect to yield approximately 1% per annum, while one could enjoy approximately a 2% yield on a blended mix of 0-5 year bonds. Sound good? Don’t get too excited. While a 2% yield is undoubtedly preferable to a 0% yield, bond yields move inversely to bond prices. This means that if interest rates rise from their current historic lows, bondholders can expect to suffer a capital loss. Bonds have already suffered significant losses after the Federal Reserve increased interest rates in December 2016, and with three more rate rises pencilled in for 2017, the pain may not be over yet. Longer term bonds offer a higher yield than their short term counterparts, but are even more susceptible to capital losses as they are more negatively affected by rising rates.
If bonds are too much risk for too little reward, perhaps equities are the answer? Historically, they have returned more than bonds, property and many other asset classes. Yet investing solely in equites is exposing oneself to the volatility of the stock market. While over the very long-run one can expect a decent return, there can also be long periods of time where the value of equities decline.
The final asset class we will consider is the one broadly classified as “alternatives”. This includes private equity, property, hedge funds and commodities. Similar to equities, they offer the prospect of significant returns, but require a long-time horizon to minimise the risk of short-term losses.
Overall, it seems as though while each asset class has advantages, no individual asset class is currently attractive enough on a risk-reward basis. However, if we combine the various asset classes together then maybe the situation becomes more attractive.
The benefits of diversifying across asset classes have been known in the investment world for decades. Harry Markowitz, the 1990 Nobel Prize winner in Economics, introduced the concept of modern portfolio theory as far back as 1952. His seminal essay provided a theoretical framework that emphasised the already well-known ideas of diversification and asset allocation. The concept was taken to the next level in the 1990s. David Swensen, the Chief Investing Officer of the Yale University Fund, pioneered a new form of multi-asset investing known as the endowment model. This approach involves diversifying across traditional asset classes such as equities and bonds, while also allocating significant portions of the portfolio to alternative instruments such as private equity, hedge funds and property.
Historically, many investors were advised to invest in portfolios with a 60% allocation to equities, and a 40% allocation to fixed income. Between 1961 and 2010 this strategy returned a nominal gain of 9.0% annually. While impressive both the Yale and Harvard endowment strategies (another proponent of the endowment model) have generated annual returns well in excess of the traditional 60/40 stock/bond portfolio.
Endowment models are time-consuming and expensive to set up, making them impractical for corporates. A more realistic approach is investing in low-cost funds which invest in multiple asset classes that replicate some of the best features of the endowment model. This gives the investor exposure to a wide variety of asset classes and provides the benefit of diversification. However, some corporates are understandably reluctant to invest in funds that they may perceive as risky.
Specifically, there are three common concerns:
While all investments are inherently risky to a certain degree, this can be reduced significantly by investing in a fund which is diversified across asset classes and holding this fund for a reasonable period of time. Let’s take an example using a hypothetical fund as outlined in Figure 3. This is a reasonably conservative portfolio with 65% composed of less risky instruments such as bonds and cash.
For illustrative purposes only
If we backtest this portfolio over the 1990-2016 period, we can see that the risk of capital loss declines significantly over a longer holding period. Indeed, over this timeframe the risk of losing capital over a three-year period was a mere 4% and there was no 5-year period of negative returns. On the upside, the average return over a three-year period was 24.3%. The 5-year annualised rolling return of 7.08% was generated due to the bull market in bonds. Going forward, an annualised return of 4% would be considered more realistic.
Source: Davy, Bloomberg
This simulated performance is based on the following instruments and indices: iShares MSCI World index Exchange Traded Fund (ETF)(15%), iShares MSCI Emerging Markets Index ETF (2.5%), EURO STOXX 50 ETF (7.5%), JP Global Government Bond Index (26%), BofA US High Yield Total Return Index (18%), Blackrock Euro Government Bond Index Fund (11%), HFRI Fund Weighted Composite Index (6%), FTSE EPRA Developed Index (4%), EURIBOR (3%) weighted as noted in brackets. These simulated figures are shown in gross terms and do not take into account the annual management fees, other charges, commissions and applicable tax which may apply and which would reduce the performance indicated above accordingly.
Companies want to know that they can redeem any investments as the need arises. To achieve this they need look no further than UCITS (Undertakings for Collective Investment in Transferable Securities) funds, which are investment funds that are regulated at European level. By choosing a UCITS fund that can be bought and sold on a daily basis, corporate treasurers are able to withdraw their companies’ money within a relatively short time period. Furthermore, many (although not all) UCITS funds are sold at a single unit price – meaning that there is no bid-offer spread.
Fees should be a primary concern for all investors. While fees vary from fund-to-fund, it is possible to invest in UCITS funds that invest in multiple assets for between 1.3% and 2% per annum depending on the fund.
Low-cost funds which invest in multiple asset classes may offer a viable alternative to the rock-bottom deposit rates currently on offer at the banks. However, it is imperative to make sure the surplus cash you are willing to invest truly is surplus. While the risk of capital loss over a 3+ year period is low, over a shorter period it is quite possible that an investment will suffer periods where it declines in value. Nevertheless, if you are reasonably certain that you will have excess cash reserves sitting idly by for the foreseeable future it is likely you can afford to consider a UCITS fund as an option.