Many happy returns

High street banks have a history of providing uncompetitive interest rates on many of their accounts, yet they remain a favoured option for many schools. Michael Quicke suggests alternative homes for your money

Historically, busy administrators have tried to find a balance between the convenience of a high street bank, with cheque book or telephone facilities, and the attractions of a money fund which provides a fair rate of interest. In an economic era of falling nominal interest rates, where the amounts earned over shorter periods can appear modest, the temptation for many is to pay the price of no income and opt for ease. But although this siren’s call of convenience can be appealing, it may not be the best solution. Assets are hard won, better returns easily achieved and any loss of service can be kept to a minimum.

Why is there such a difference in rates? To answer this, we have to look at what each is providing. The high touch service from banks is comprehensive, but it isn’t cheap. The investment in a branch network and the staff to support it is huge and costly. That payment in part comes from the interest earned on customers’ deposits. Getting clarity on what is actually on offer can be difficult.

From time to time, special higher rate deals will be offered to bring in new deposits, perhaps when a bank needs to grow the liability side of its balance sheet, or to generate some good PR. But these are tactics not commitments, a means to an end. What almost inevitably follows is an erosion of the special deal over time, with the inertia of stay-put customers giving benefit to the bank long after the benefit to the customer has been taken away.

Deposit values
In contrast to this complex world, the offer from a good quality deposit fund is very straightforward; no bells and few whistles, just a good rate of interest. It’s a simple business model which has at its heart a single objective.

So the choice is between the multi-service model of the bank, which has to be paid for, and a purpose-built structure with few frills but where the advantages of the lean structure are passed on in rates.

What are the important factors in the relationship between lender and borrower? Obviously, use of the cash deposit itself, but the time period will also be important. In money funds, although a holder can leave at any time, in practice few do. This means there is a large core of deposits which are stable and long-lasting, and a relatively small amount of the fund which churns as investors join and leave. Because of this underlying stability, the manager of the fund can structure the portfolio to take advantage of conditions in the money markets, perhaps by lending part of the assets for slightly longer periods.

Longer term deposits tend to receive higher interest rates, so the structure of the fund, properly used, can give immediate gains to investors. Set against this is risk, and on two levels.

Administration risk can occur when poor operating systems at the manager fail the customer. Sorting out poor administration is expensive and time-consuming for all concerned. Funds, of course, do not have a monopoly on this. Much more seriously, there is investment risk.

Avoiding the risk
Deposit funds lend money to companies and a poor choice, perhaps in pursuit of an additional point of yield, can have a disproportionate effect on returns. The best funds, of course, recognise this risk and take every step to avoid it. Portfolios are diversified, exposures to any single borrower are limited and all potential borrowers are vetted by using the resources of the major rating agencies and inhouse credit review teams. Funds built to the highest standards are recognised by agencies such as Moody’s as being very low risk. The best receive an Aaa rating – triple A, as good as it gets.

If a deposit fund can boost income so substantially, why do some schools still hold back from using them? One factor is uncertainty over the timing of when monies will be required.

There is often an assumption that any funds that could be needed at short notice should be treated as if they will be needed on this basis. This is great news for the banks, but it’s an expensive way to hold reserves. It is also unnecessary.

Most deposit funds offer daily dealing and can move monies directly to a client’s bank via electronic transfer in good time to meet planned expenditure.

Competition between deposit funds is strong and extends beyond the provision of attractive rates into areas such as customer service. Perhaps a sensible working methodology is to use accounts based on their strengths, maintaining a current account for day-to-day needs, but actively moving the excess into an account which pays its way.

Which deposit fund to use?
The best funds offer sensible virtues put together in a transparent way. These virtues are:

• prudence, because the gain from taking risk is modest, the cost of getting it wrong is substantial;

• skill, because good performance depends on making the right decisions – making a wrong decision, on the direction of interest rates, for example, will undermine relative returns; and

• scale, because big funds can have lower costs, which means better returns for investors and more sophisticated investment strategies.

Those who fail to recognise that cash is a valuable asset, capable of making a real contribution to returns, are at risk of missing out. The banks want to sell a service that suits their structure and which pays for their cost base. Sometimes it is right to buy it, but at other times better choices can be made.

Michael Quicke is the chief executive officer of CCLA Investment Management.

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