Learning Objective
3.1.1 Know the role of money as a financial asset: cash deposits; money market instruments; money market funds
Nearly all investors keep at least part of their wealth in the form of cash, which will be deposited with a bank or other savings institution to earn interest. Cash investments take two main forms: cash deposits and money market instruments.
1.1 Cash Deposits
Cash deposits generally comprise banks or other savings institutions, accounts, all of which are targeted at retail investors, though companies and financial institutions make short-term cash deposits with banks. The main characteristics of cash deposits are:
• The return simply comprises interest income, with no potential for capital growth.
• The amount invested is repaid in full at the end of the investment term.
The interest rate paid on deposits is usually:
• a flat rate or an effective rate (also known as an annual equivalent rate (AER), that is compounded more frequently than once a year);
• fixed or variable;
• paid net or gross of tax;
• dependent upon its term and/or notice required by the depositor. Fixed-term deposits are usually subject to penalties if an early withdrawal is made.
Deposits are usually protected by government-sponsored compensation schemes which pay a substantial proportion of deposits lost because of the collapse of a bank or building society. These facts were brought into sharp focus during the 2007–09 period when a number of governments bailed out banks and increased the amount of deposit protection.
1.1.1 Overseas Deposits
Where cash is deposited overseas, depositors should also consider the following:
• The costs of currency conversion and the potential exchange rate risks if deposits cannot be accepted in the investor’s home currency.
• The creditworthiness of the banking system and of the chosen deposit-taking institution and whether a depositors’ protection or compensation scheme exists.
• The tax treatment of interest applied to the deposit.
• Whether the deposit will be subject to any exchange controls that may restrict access to the money and its ultimate repatriation.
1.1.2 Fixed-Term Deposits
Fixed-term deposits can also be made in the interbank market. The interbank market originally served the short-term deposit and borrowing needs of the commercial banks, but has since been tapped by institutional investors and large corporates with short-term cash surpluses or borrowing needs. The term of deposits made on the interbank market can range from overnight to one year, with deposit rates being paid on a simple basis often at the London Interbank Bid Rate (LIBID) and short-term borrowing being charged at the London Interbank Offered Rate (LIBOR). There are regulatory investigations and criminal prosecutions in the US and Europe into alleged manipulation of LIBOR rates, so alternative benchmarks such as SONIA and EONIA (the Sterling OverNIght Index Average and the Euro OverNight Index Average) are being increasingly used.
1.2 Money Market Instruments
The money markets are the wholesale or institutional markets for cash, and are characterised by the issue, trading and redemption of short-dated negotiable securities, usually with a maturity of up to one year, though typically three months.
Due to the short-term nature of the market, most instruments are issued in bearer form and at a discount to par (see Section 3.1.4) to save on the administration associated with registration and the payment of interest. Direct investment in money market instruments is often subject to a relatively high minimum subscription, and therefore tends to be more suitable for institutional investors. Money market instruments are, however, accessible to retail investors indirectly through collective investment funds.
The main types of money market instruments are considered below.
1.2.1 Certificates of Deposit (CDs)
CDs are negotiable bearer securities issued by commercial banks in exchange for fixed-term deposits.
They have a fixed term and a fixed rate of interest, set marginally below that for an equivalent bank time deposit. The holder can either retain the CD until maturity or realise the security in the money market whenever access to the money is required. CDs can be issued with terms of up to five years.
They are also an important means by which banks can borrow or lend reserves between themselves.
As they are a fixed-interest security, the price will fluctuate with the competitiveness of the interest rate compared to the prevailing yields, thus exposing holders to potential capital gains or losses.
1.2.2 Commercial Paper and Bills of Exchange
Commercial paper is the term used to describe the unsecured negotiable bearer securities, or short-term promissory notes, that are issued by companies with a full stock market listing.
These securities are issued at a discount to par and in the US have maturities of up to 270 days but with an average of around 30 days. Being redeemed at par, the return on commercial paper entirely comprises capital gain.
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Another short-term financing instrument that can be issued by companies is a bill of exchange. A bill of exchange is essentially an invoice, for goods or services supplied, which states the amount and date by which this amount is due to be paid by the recipient of the transaction. Once the obligation to pay this amount by the due date is formally accepted by the party in receipt of these goods and services, the instrument becomes a negotiable bearer bill and can be traded at a discount to its face value until maturity. To minimise the credit risk associated with holding such a bill, and to narrow the discount at which it can be sold, the issuer may obtain the formal acceptance of an eligible bank to guarantee the face value of the bill at maturity.
1.2.3 Treasury Bills
Treasury bills, which are issued by governments, are similar to commercial bills in that they are issued at a discount to par while being redeemed at their nominal value.
Most governments that issue Treasury bills (UK, US, Germany, France) issue them in three-, six- and 12-month bills. Treasury bills are highly liquid and act as the benchmark risk-free (actually, minimal-risk) interest rate when assessing the returns potentially available on other asset types.
Treasury bills are used as a monetary policy instrument to absorb excess liquidity in the money markets so as to maintain short-term money market rates, or the price of money, as close as possible to base rate.
1.3 Money Market Funds
Money market instruments are primarily used by the Treasury operations of central banks, international banks and multinational companies and are traded in a highly sophisticated market. This does not mean, however, that they have no role to play in the investment management of a client’s portfolio.
They can have a very useful and significant role to play but need to be accessed through specialist investment funds.
Money market accounts can be used as a temporary home for idle cash balances rather than using a standard retail bank account. For the retail investor these accounts can offer higher returns than can be achieved on standard deposits, and money market accounts are offered by most retail banks. The disadvantage is that the higher returns can usually only be achieved with relatively large investments.
The adviser should therefore consider the merits of using a money market fund, where the pooled nature of this collective investment vehicle can enable access to better rates with smaller deposits.
Placing funds in a money market account means that the investor is exposed to the risk of that bank. By contrast, a money market fund will invest in a range of instruments from many providers, and as long as they are AAA-rated they can offer high security levels.
To assess whether a money market fund is suitable for inclusion in a portfolio, the adviser needs to consider a number of issues, including:
• the relative rate of return compared to a money market account or other cash deposit;
• the charges that will be incurred and their effect on returns;
• speed of access to the funds on withdrawal;
• the underlying assets that comprise the money market fund;
• how the creditworthiness of the underlying assets is assessed;
• the rate of return compared to other money market funds and how that is being generated;
• the experience of the fund management team.
In the light of market events in 2008 when some funds ‘broke the buck’ (ie, when the net asset value dropped below $1 per share), the European Securities and Markets Authority (ESMA) issued guidelines for a common definition of European money market funds. The guidelines set out a two-tiered approach for a definition of European money market funds:
• short-term money market funds;
• money market funds.
This distinction recognises the credit risks inherent in the underlying portfolio of a money market fund.
It should be noted that money market funds may invest in instruments where the capital is at risk and so may not be suitable for many investors.
In addition, money market funds can be differentiated by the currency of issue of their assets. The European Fund and Asset Management Association (EFAMA) fund classification statistics have over 220 funds from 15 different fund management groups.
1.3.1 Summary
Money market investments can fulfil a number of roles within a client’s portfolio, including:
• short-term home for cash balances;
• as an alternative to bonds and equities;
• as part of the asset allocation strategy.
Money market funds also offer a potentially safe haven in times of market falls. When markets have had a long bull period and economic prospects begin to worsen, an investor may want to take profits at the peak of the market cycle and invest the funds raised in the money markets until better investment opportunities arise. The same rationale can be used where the investor does not want to commit new cash at the top of the market cycle. The nature of money market instruments means that they offer an alternative investment that does not give exposure to any appreciable market risk.
Within a normal asset allocation, a proportion of funds will be held as cash. Money market investments can therefore be the vehicle for holding such asset allocations, depending on how the rates on offer compare to other accounts that offer easy access.
Money market funds, therefore, have a core role to play in an investment portfolio. It needs to be remembered, however, that they still carry some risks. The short-term nature of the money market instruments provides some protection, but short-term interest rates fluctuate frequently, so they can still be exposed to price volatility. Investor compensation schemes protect bank deposits, but would not protect an investor from losses arising from money market movements.
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2. Property
Learning Objective
3.2.1 Know the key features of property investment: property funds; Real Estate Investment Trusts (REITs)
2.1 Direct Property Investment
As an asset class, property can provide positive real long-term returns allied to low volatility and a reliable stream of income.
Property as an asset class is unique in its distinguishing features:
• Each individual property is unique in terms of location, structure and design.
• Valuation is subjective, as property is not traded in a centralised marketplace, and continuous and reliable price data is not available.
• It is subject to complex legal considerations and high transaction costs upon transfer.
• It is highly illiquid as a result of not being instantly tradeable.
• Since property can only be purchased in discrete units, diversification is difficult.
• The supply of land is finite and its availability can be further restricted by legislation and local planning regulations. Therefore, price is predominantly determined by changes in demand.
An investment manager needs to consider whether exposure to the residential or commercial sector is appropriate for the portfolio they are managing. It is therefore important to understand the differences between the two. Some of the key differences are:
Residential Property Commercial Property direct investment is limited to property companies and institutional investors Tenancies Typically short renewable leases Long-term contracts with periods
commonly in excess of ten years Repairs Landlord is responsible Tenant is usually responsible Returns Largely linked to increase in house
prices
Significant component is income return from rental income
Direct investment in property confers a number of advantages. As an asset class, it has consistently provided positive real long-term returns, through rental income and/or capital appreciation allied to low volatility and a reliable stream of income. An exposure to property can also provide diversification benefits owing to its low correlation with both traditional and alternative asset classes (although that correlation can quickly increase during periods of market stress).
However, property can be subject to prolonged downturns, and its lack of liquidity and high transaction costs on transfer only really make direct investment suitable as an investment medium for long-term investing institutions, such as pension funds. What is also fundamentally different from other assets is the price. Only the largest investors can purchase sufficient properties to build a diversified portfolio.
These tend to avoid residential property and instead concentrate on commercial and industrial property and also farmland. Smaller investors wanting to include property within a diversified portfolio instead seek indirect exposure to property. This can be obtained through either a collective investment scheme, property bonds issued by insurance companies, or shares in publicly quoted property companies.
The risks associated with property investment include: