What Are Cash Equivalents?

A portfolio of investments will not always be 100% in securities.  An amount of the portfolio can be held in cash.
When a portfolio is set up, operationally, it can be set up so that any cash is invested into interest-earning instruments (so it makes some money, not much, but some).
Example of cash equivalents are:
* STIF (short-term investment fund) or
* Money market fund

What is the Difference Between a STIF and Money Market Fund?

1. Money Market Funds
Money market fund accounting differs from other types of funds, such as mutual funds.
Although it is similar to a bond fund in the fact that it holds bonds that fluctuate in value, the difference is that the money market fund’s NAV does not exactly tie to the underlying market values of the bonds its holds.  The fund uses  amortized cost accounting to keep its NAV stable and pays out a stable interest rate.   This is best illustrated by the following excerpt/example from ICI Institute’s “Pricing of U.S. Money Market Funds“:
Many of the securities that money market funds invest in—such as commercial paper, Treasury bills, and certain agency securities—are “discount securities.” Discount securities do not pay explicit interest. Instead, interest is accrued implicitly.
When discount securities are first sold, they typically sell for less than face value, that is, at a discount. At maturity, the investor receives the face value. The difference between what the investor paid and the amount received at maturity is implicitly accrued interest. For example, a fund may pay $99.40 for a security that will return $100 in 60 days. The face value of the security is $100; the purchase price of the security is $99.40; and the discount is $0.60. The fund books the security in its portfolio at an initial amortized cost of $99.40. The amortized cost method allows the fund to increase the amortized cost value of the security each day by the amount of the daily interest accrual—generally computed as the difference between the face value and the purchase price divided by the remaining maturity of the security. In our example, the daily accrued interest would be one cent ([$100 – $99.40]/60).
By valuing its securities at amortized cost, a money market fund can maintain a stable $1.00 NAV because the amortized cost of securities—the purchase price plus accrued interest—increases at a predictable rate each day. A money market fund declares a daily dividend to fund shareholders equal to the accrued interest on the fund’s portfolio (less accrued expenses). In our example, the daily one-cent increment to the amortized cost value of the security is offset by recording a dividend payment (net of fund expenses) payable to fund shareholders each day. At the end of each day, the fund’s per-share NAV based on the amortized cost value of the fund’s portfolio securities has the same accounting value as the day before.9 Thus, from day to day, the fund’s NAV per share remains stable at $1.00.
2. STIF Vehicles
From an accounting standpoint, STIFs are similar to money market funds.  They have $1 NAV and invest in highly liquid, low risk securities.
One main difference between the two is that Money Market funds are open to retail investors, whereas STIFs are available to authorized fiduciary accounts (I found this description of the difference on the bottom of page 39 on this document).

 

How are STIF or Money Market Vehicles Selected?

The STIF or money market vehicle may be selected by the client or portfolio manager.
From a performance standpoint, it does not matter who selects the cash though.
According to GIPS, as long as the firm controls the allocation to cash, then the performance of the cash is captured regardless of who selected the cash vehicle.  See the below Q&A from the GIPS website.

Firm A manages the portfolios of several clients and has full investment discretion over their assets. At the end of each day, the excess cash in each portfolio is swept into the custodian’s money market fund. Since Firm A does not manage the money market fund, it does not include the cash portion of the portfolio in its total return performance calculation. Is this practice in compliance with the GIPS standards?

No. Even if Firm A does not control the cash investment, it does control the amount of portfolio assets that are held in cash equivalents. Since Firm A chose to have portfolio assets “invested” in cash, Firm A is responsible for the return the cash assets earn and it must be included in the total return of the portfolio.

Categories: Cash
Source: GIPS Handbook, 2nd Edition

 

How is Interest Calculated on a STIF or Money Market Vehicle in a Portfolio Accounting System?

In the portfolio accounting system, that fund is set up as a security with an interest rate. Typically, its an annual rate of interest that is multiplied by 30/360 and from there a daily rate is derived.
If the interest is being accrued, that daily rate is multiplied by the balance in the cash equivalent bucket (principal balance) and the interest is added to the accrued interest balance.
Depending on how often that interest is paid and reinvested, the accrued interest balance will be moved into the cash equivalent security and start earning interest as well.

 

What Does “Cash Sweep” Mean?

Typically, the movement of cash into the STIF or money market vehicle can be automatically set up to “sweep” the uninvested cash into the fund. “Sweep” is another way of saying that the system makes an automated transaction to invest in the vehicle.

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