The aim of cash management is to make use of idle funds by choosing the appropriate investments and providing adequate liquidity, while generating income and producing higher yields. These goals align exactly with the advantages of an active portfolio strategy in today’s environment.
Given the financial disruption over the past year, a prudent cash management strategy has proven to be vital in meeting investor objectives of preservation of capital, liquidity and return. As we witnessed, many investments once viewed by many to be safe, such as auction rate securities and enhanced cash funds, deteriorated as liquidity dried up. Successful investors not only avoided these unsound investments, but also adopted an active management style to take advantage of opportunities to maximize performance. As we slowly emerge from the current recession, utilizing the tools of an active trading strategy will help create a better optimized portfolio that balances risk and return.
Positioning on the Yield Curve
For over a year, the Fed has held its target rate between zero and 0.25 percent. Correspondingly, the yield curve has steepened as market participants expect higher rates and inflation in the future. This has created opportunities to lock in higher yields outside of the one-year period and “roll down” the curve. This means the maturity of the investments will naturally shorten over time. For instance, a two-year note will only be a 1.5-year note after six months. Because of the steep yield curve, this note will carry a higher price than the current, lower-yielding securities of comparable maturity, holding all else equal. Therefore, an active manager, in theory, has the flexibility of sustaining a higher level of income by reinvesting back out on the curve. This strategy provides a means to maintain a portfolio duration target, while maximizing return in an extended low yield environment.
Yields begin to accelerate outside of the one-year period.
Optimal Asset Allocation
An important element of any active strategy is to incorporate relative value in building and managing a diversified portfolio. Creating an optimal asset allocation among various security types will help position the portfolio to maximize yield, while minimizing risk. The weighting of different asset classes will depend on factors such as yield spread and the economic environment.
For example, a portfolio can be rebalanced to take advantage of higher yields when spreads between corporate credit and Treasury notes widens. This strategy would also be true in an environment where the economy is recovering and corporate debt is expected to outperform. In addition, swapping between credit names and sector rotation will take advantage of situations when credit is cheap, and selling when credit becomes more expensive. These incremental changes and reallocations may be small, but can provide enhanced benefits to performance in the long run.
A diversified portfolio will balance credit risk, liquidity needs and maximize return.
Managing Volatility
For now, the expectation is that the Fed will maintain the exceptionally low rates for “an extended period.” Market rates, however, have not been immune to volatility. For example, the yield on two-year Treasury notes has ranged from a low of 0.67 percent to a high of 1.40 percent during 2009, even as the Fed consistently reiterated their stance on keeping rates unchanged.
Managing volatility is vital for any portfolio. The market often moves and reacts ahead of itself as participants digest the latest data points and often make trading decisions based upon an emotional reaction. An active strategy would not only help adjust for and contain the volatility, it could also take advantage of conditions to improve a portfolio. The market fluctuations offer several benefits, including locking in higher yields or selling out of overvalued positions for gains.
Periods of high volatility will often move security prices, creating misalignment.
Looking Forward
The economy still faces certain recovery headwinds and as the pace of economic growth increases, the Fed will need to raise rates. Having an active cash strategy will incorporate proper risk management, accounting for interest rate movements, credit exposure and market volatility. An active strategy will adjust accordingly to the changing economic landscape and financial markets, taking advantage of opportunities while seeking to avoid pitfalls that may jeopardize principal or liquidity.
SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. Products offered by SVB Asset Management are not FDIC insured, are not deposits or other obligations of Silicon Valley Bank, and may lose value.
This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.