In the current market, investors could be forgiven for keeping cash in a shoebox under the bed. But with tempting bank rates on offer and ongoing volatility in bond and equity markets, many are more inclined to increase their cash holdings.

Cash is often an afterthought in a portfolio, but investing in it can generate an additional one to two per cent per year. This is not to be sniffed at in the current environment, where returns are hard to come by. It is easy to be seduced by headline rates, but research can pay dividends.

In the long term, holding a high cash position is risky. Although cash was the best-performing major asset class in 2007 (with a post-inflation rise of 1.8 per cent, according to the Barclays Equity Gilt study), it has historically underperformed both equities and bonds over most time periods.

The limits of cash
Unless it is index-linked, cash will not protect against inflation and, although investors will get their money back, they are likely to see its buying power eroded.

That said, investors will always need to hold at least some of their portfolio in readily available funds. Most advisers use a rule of thumb of around three months’ salary as ‘emergency money’.

Older investors, in particular, may not want to risk their money, simply wanting preservation of capital and a steady income. Their cash holdings will depend
on their attitude to risk and income needs.

Until the problems with Northern Rock emerged, the traditional first choice for holding cash has been a savings account. In general, savers need to consider the interest rate, the degree of access to their money and, particularly post-credit crunch, the safety of the institution.

Basic principles
Savers should pay attention to how interest is calculated. If it is monthly, investors will benefit from compound interest and end up with a better return than if interest is calculated annually.

Banks and building societies will often lure investors in with a high headline rate, only to change it if interest rates are cut. As a result, research group Moneyfacts now lists ‘most consistent’ savings accounts alongside highest rate accounts.

As borrowing from other banks (the inter-bank market) has become more difficult, banks have offered attractive rates to attract more savers and balance their books.

Access versus return
If investors are willing to give up instant access, rates will often be higher. For many people, however, the whole point of holding cash is that it is available in emergencies. Some accounts have bonuses for leaving money in place for a set period of time, but investors need to be sure that they are sufficiently compensated for tying their money up, as the rate they receive will often only differ by 0.5 to one per cent.

Over past years, internet savings accounts have provided the best rates, but that is changing with foreign groups like Icesave and ICICI Bank featuring on the
best-buy lists. Danny Cox, head of intermediary practitioners at Hargreaves Lansdown, says, ‘Now the best-buy lists are populated by organisations that people haven’t heard of, offering very good rates. On the whole, we suggest that people opt for UK-based clearing banks. There is nothing wrong with foreign companies, but UK banks and building societies are likely to offer better protection. Northern Rock set a precedent for what would happen to UK savings institutions in difficulties. The Bank of England is unlikely to step in to support, for example, a Finnish bank.’

All savings accounts, including those from overseas institutions, are covered up to £35,000 under the FSA’s Financial Services Compensation Scheme. Investors should spread their investments across a number of institutions to ensure they are fully covered.

Making the right choice
If investors are holding cash pending investment in the stock market, a number of the advisory groups are offering interest on equity ISA accounts for three to six months. While these rates are well under those of a savings account, they provide an investor with some room to decide on their equity strategy in volatile markets.

The main option for investors looking for longer-term cash management is money market funds. These are popular in continental Europe, but are less frequently used by UK investors. Marc Doman, managing director of Invesco Aim, says that money market funds tend to be largely commoditised because the requirements for an AAA rating are so tight. As a result, the difference between the top- and bottom-performing funds is small, at around 0.15 to 0.2 per cent.

Doman says that money market funds are run along reasonably uniform lines, with around one-third in overnight holdings for liquidity purposes and two-thirds in longer-term instruments. He says, ‘The main considerations for a money market manager are safety, liquidity and yield. But these are not fundamentally return products, they are about security and liquidity.’

The overnight investments will be in bank deposits or repurchase agreements. The remaining funds will be in debt instruments of less than one year. These may be bank certificates of deposit, floating rate notes, commercial paper or asset-backed commercial paper. These are all different types of loan. Doman says that money market funds act as mini-banks, bringing money in and then lending it out on a short-term basis.

A window of opportunity
The fees on these funds tend to be small, at around 0.15 per cent, but this is not universal and Ash Kumar, investment fund analyst at Morningstar, says that investors need to ensure that fees are not eating into the overall return.

At the moment, there is an anomaly as a result of the recent credit crunch, in that the rate at which banks borrow from each other (Libor) is significantly higher than the base rate.

Rob Burdett, joint head of multi-manager at Credit Suisse, says ‘Cash funds are paying a better rate than the base rate because they are linked to Libor. The inter-bank rate is higher than base rates because of a lack of trust between banks.’

Burdett looks for a number of things when selecting a money market fund: FSA regulation, distributor status, sensible settlement periods, daily interest calculation, low counter-party risk and an interest rate in excess of Libor. He uses the HSBC Sterling, Fidelity MoneyBuilder and F&C Money Market funds.