By David Scobie*
“We always keep enough cash around, so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future.” - Warren Buffet.
As the above quote indicates, the primary role of cash is to serve as a valuable pool of liquidity, available to meet investors’ short-term liabilities and to protect investors from falling into the trap of forced asset selling to cover their outgoings. However, in the current market environment, investors with high risk aversion may have other reasons to hold cash. 2018 reminded us of the real risk that global bonds and equities may produce negative returns in the same period, with cash outperforming both. With historically low bond yields following a decade of loose monetary policy in developed markets, the relative attractiveness of bonds becomes more open to question and cash could offer tactical advantages in an investor’s toolkit.
“Cash” in this article refers to professionally-managed funds offered by investment managers. These funds typically hold very-short-dated fixed income instruments such as treasury bills, bank floating rate notes and commercial paper. Such money market investments are frequently regarded as being as safe as (or safer than) holding deposits in a bank, while providing a marginally higher yield.
Cash primarily provides liquidity
How much money or how many outgoings an investor requires from a portfolio at any one time can be described as the liquidity need. The level of liquidity required, and where it is sourced from, can be informed via a liquidity budgeting exercise which stress-tests an investor’s ability to cope under different (including highly challenging) environments. Cash is clearly not the only liquid asset, and the process tests the liquidity across the asset base. However, cash is somewhat unique in being both highly liquid and exhibiting almost no downside risk.
It’s worth noting that what cash consists of can be a broad universe. An investor in a cash fund needs it to be true to its label, and this will depend on the fund’s underlying construction. Most famously, in the global financial crisis (GFC), the largest US cash fund, the Reserve Fund, “broke the buck” (i.e. its net asset value fell below $1) due to a significant holding of now-defaulted Lehman Brothers’ notes. In this exceptional environment, cash funds (as investors’ most liquid asset) faced significant redemption demands and, as a result, some mark-to-market losses. This result was akin to a run on a bank, with investors withdrawing money for fear their cash holding was not truly low default risk “cash.”
In the years following, regulation in some countries limited the underlying holdings that a cash fund can hold, thereby helping ensure cash is truly vanilla in nature. However, investors should be aware of the underlying securities of cash funds and check that these are in line with their investment objectives and reasoning for holding a cash investment.
Liquidity is often the most overlooked risk in asset allocation. It provides oxygen to markets and seems ubiquitous when confidence is high, but can disappear in a flash when most needed.
Cash is not a long-term investment
While how much liquidity is required is a strategic choice, how much liquidity is desired (in excess of that) is a function of a shorter-term or dynamic asset allocation decision process. This will reflect two things: (1) the strength of an investor’s views in relation to the balance of risks and opportunities in investment markets at any one time, and as importantly (2) the robustness of an investor’s decision-making process so as to effectively implement a dynamic approach over time. The latter, in particular, is easier said than done. Opportunistic investors tend to have more cash at hand so they can readily capitalise on prospective “big wins” as they emerge. Investors who are more long-term strategic in their approach do not hold large pools of cash because of its limited return potential. In the context of long-term investing, a holding in cash is often seen as “underinvested.”
Figure 1 clearly highlights the opportunity cost of investing in cash. It also shows the 10 years since the GFC when cash returns were very poor relative to riskier assets, especially equities, due to low to zero official interest rates and quantitative easing (QE).
Rates during this period challenged the conventional wisdom that the cash rate should be at least equal to the rate of inflation or higher. The median US real interest rate for the period since 1972 has been around 1% per annum, but for much of the post-GFC period real interest rates have been negative in most developed countries, as is the case in New Zealand now.
Winning by not losing
Although it is difficult to maintain a long-term return-based rationale for holding cash, a stronger case could be made for including cash in more conservative portfolios to help with risk reduction. Total multi-asset portfolio risk can be reduced in one of three ways:
- Increase exposure to negatively correlated assets (increase diversification and downside risk characteristics)
- Increase exposure to low positively correlated assets (increase diversification and therefore risk-adjusted return)
- Reduce exposure to higher risk assets in favour of lower-risk assets (reduce average risk per dollar invested).
Historically, government bonds have met the first criterion. This is why bonds have typically been the “40” in a traditional “60/40” portfolio. Cash really meets only the third criterion and is why long-term strategic allocations have preferred longer-term bonds for risk reduction. However, the current low level of bond yields serves to reduce the relative attractiveness of bonds.
Over a quarter of global investment grade bonds, worth US$14 trillion, are now yielding below zero.
Mercer’s unconstrained balanced reference portfolio includes allocations to cash as well as government bonds to manage downside risk. This is on the grounds that, while government bonds may still provide some negative correlation benefit in a severe equity market setback, there are certain conditions - captured in our stress tests - that could see both bonds and equities fall together.
Such conditions were seen in 2018 – generally a poor year for investors – in which more asset classes had negative returns than in 2008. Investors were reminded that equities are indeed volatile, and that in environments where markets become concerned about inflation and interest rate risk, both equities and bonds can produce weak returns at the same time. Cash emerged as a winner, simply by not losing.
In the current environment, yields on short-term debt instruments are so low that, to boost returns, investors are tempted to take on more risk via longer duration or more credit. However, there is a very low yield premium for extending out the yield curve and, in the process, accepting higher sensitivity to interest rate movements.
Over the 10 years that have passed since the GFC, low inflation expectations and historic experiments in monetary policy have underpinned a broad bull market in investment assets. Investors with a strategic allocation to cash would have seen a significant return drag in their portfolio compared to traditional stocks and bonds.
However, what the next 10 years hold may differ greatly. 2018 was a good example of a market that is wary of central banks reducing the support they have offered post-GFC. The Federal Reserve, now back in easing mode, has proven responsive to the emerging economic outlook. A scenario of tight labour markets feeding through to inflation would likely see the Fed shift again from support to constraint. In such an environment, weak or negative returns from both bond and equity assets could be a realistic outcome.
Even in the absence of a tightening monetary policy environment, the outlook for global growth and trade remains uncertain. Investors who are tactically-inclined, and have the governance capability in place, could be wise to keep some “dry powder” in their portfolio on top of immediate liquidity needs, ready to deploy in the case of significant market turmoil. Hence, while for many investors cash has still not ascended the throne, for some it can play a useful positioning role in a portfolio.
*David Scobie is head of Consulting (NZ) at Mercer Investments. This article does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.