Interest in interest

30 November 2016

Fraser Donaldson – Insight Analyst (Funds and DFM)

A client who holds cash at their own bank or building society would expect to receive interest. Granted, that for an instant access basic savings account the rate could be as low as 0.05% AER Gross. Special offers and introductory rates can see interest as high as 5%, albeit usually for a short period.

I find it strange that so many discretionary fund managers (DFMs) pay no interest at all on client cash, and I am talking about cash as an asset here, not the trading account or the income account. Of the 110 discretionary solutions that have given Defaqto information on the level of interest paid to clients on cash held, only 32 paid any interest, 78 pay no interest, or the current rate is set at zero.

Of those that do pay interest, the rate varies from 0.05% up to 0.4%. Quite a difference. The main reason that we have been given for zero rates by DFMs is that the third party custodians do not pass on the interest earned. If you want to find out which DFMs do and do not pass on the interest, this information is available within Engage, Defaqto’s industry leading financial planning software.

Now, the numbers above are from bespoke portfolios and managed portfolio services (MPS) where custody is through the DFM. We have not included MPS on a platform as payment of interest is down to platform policy. This is something to bear in mind when undertaking due diligence on the platform of choice and possibly something the DFM should consider when partnering with a platform.

However, is this all a fuss about nothing? Interest rates are almost negligible, cash positions tend to be relatively small and only in place for a short period. Let’s think this through.

The current base rate is only 0.25%. Since I started work in November 1980, for nearly 25% of the time base rates have been above 10% and for nearly 40% of the time they have been 7% or above. Long term average base rate is more like 5%. It is only since the financial crisis in 2008 that interest rates have been so unusually low. No-one knows what the future will bring or the monetary policy that future governments will adopt, so we cannot, and should not, be confident that interest rates will stay low.

Let us take the long term average of 5%. Would your clients be happy that their discretionary manager still didn’t pay any interest on their cash allocation? I am not so sure. With one eye on the future, the first element of due diligence in this area is to be clear on the discretionary manager’s policy on paying interest on the clients cash allocation.

If only it were as simple as considering those discretionary managers that paid a competitive rate of interest on client cash. There are other considerations and some mitigating circumstances.

Firstly, I think we would all agree that if the discretionary manager anticipated a significant market fall correctly and had put the client in cash during that fall it would be classed as a successful tactical asset allocation call. The client would be relieved and perhaps not quite so bothered whether they were receiving 0%, 0.05% or 0.4% gross for a month or two.

Secondly, although I have not discovered any as yet, I am led to believe that some discretionary firms do not charge fees on cash. This policy does change the way I would think about this issue. Certainly at the moment, I would rather be paying no fees on cash and receiving no interest rather than paying full fees and receiving a low level of interest. But, this preference would change as interest rates rise.

Now, suppose that the discretionary manager does not take fees on client cash allocation. There is a potential conflict of interest here. Stay invested in risk assets and continue taking fees or move to cash and take no fee for a time. There would need to be some tight governance around this and worthy of some deeper due diligence.

Finally, do not make the mistake of automatically preferring the highest rate. The regulators would see diversification of deposits amongst a number of banks, preferably with good credit ratings and financial strength, as good practice. Of course, if rates are an average of several deposit accounts, they will tend to be lower than a single high paying deposit account, the upside being that the client is better protected.

In summary, if interest rates on client cash allocation are important, think about the following:

  • Are the zero payers just low payers?
  • What happens if interest rates rise sharply?
  • Does it make a difference if the DFM does not charge fees on client cash allocations?
  • Is client cash diversified among a number of banks?
  • Is the rate the client gets too good to be true? Check the credit rating of the deposit taker.
  • Most importantly, what are the client’s expectations and what seems fair to them?

I am always sceptical when I hear the phrase ‘a new paradigm’. I do not believe interest rates will always remain low and neither do I believe that a guaranteed nil return on an asset, however defensive, is acceptable (unless very short term, and fee free). Defaqto certainly consider the payment of some interest on cash important enough to be a criteria in our DFM Star Rating. I read that globally, institutional allocations to cash are on the up so advisers should at least be considering what return can be achieved on cash by their discretionary manager partners, if not in the short term, certainly over the longer term.

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