Diversification can include cash – for a while
HOW BAD – really – is cash in the bank, earning interest in a volatile, low return, deflationary or potentially deflationary environment? I say some cash-earning interest at 2,5% above inflation while the SA Reserve Bank sticks to healthy policies isn’t bad at all – as long as it’s a temporary parking place and you or your fund or adviser have a well-researched strategy to switch from cash to finding value. Some of the best funds out there have realised that and also have fairly high current cash levels.
After the biggest recession tremors since the asset price destruction that led to market lows in 1932, economists and analysts have startlingly contrasting opinions about risk and where to find rewards over the next few years. By now investors should also be convinced deflation risks and a lower return environment are still real. Deflation involves falling asset prices and falling demand for goods and services and lower interest rates and yields.
And investors also know that once the deflation “ouch” has been dealt with, the next ouch in a year or further out will probably be inflation, also a destroyer of value. Getting it right or right enough to find real returns is a worry. Will the fund I’m in handle both scenarios? Right now it feels best to be overweight in cash, say many now humble investors.
Yet feeling safe in zero volatility, cash can be costly and shouldn’t become a habit. Over the long run we all know a mix of blue chip equities bought at decent “value” and held patiently over the long term give vastly superior returns (equities did 245 times better than cash between 1957 and December 2009, according to Sanlam Investment Management). Being in cash may also have a lost opportunity cost by missing a good investment, as investors who bailed out in 1998, 2003 or 2009 will know.
In some of these columns I’ve talked about how your adviser or fund manager needs the tools to handle both a volatile investment environment and one in which he may have to deal with opposite extremes in pursuit of value. I argue the more flexible the skills, tools and mandate a fund or portfolio manager has, the better his chances of navigating accelerating trends – up or down. The mandate that allows a fund manager to diversify with enough flexibility to be overweight in cash at times is an important arrow in his quiver during difficult markets. Such a fund may be a flexible or a balanced fund, or even some current equity funds: it all depends on the mandate your managed investments have.
The equity fund that has to stay, say, 75% invested in stocks at all times can do little but ride with the best of a bad bunch when generational scale, lengthy or deep bear markets occur. And they can occasionally happen. Think of Japan between 1989 and now (down 75%) and the 1929 to 1954 Wall Street bear. On the other hand, there are equity funds that have to stay invested with very little cash that have shown superior returns over several bull and bear cycles – when the bear markets were brief. SA hasn’t had a lengthy bear market for generations. Enough said.
Though volatility is a favourite fudge for investing sins and often misunderstood, its main drawback is its negative effect on the rate of compounding, as investment inflows and outflows battle the swings. Or the fund manager may not have the skills, tools or mandate to benefit much from volatility. In an interesting “must read” in Nedgroup Investments’ Q3 newsletter, Matthew de Wet shows how over a 20-year period a higher volatility fund underperformed the lower volatility fund by 25%: the higher the volatility, the larger the gap between average and compound returns. The volatility attrition effect gets worse when investors withdraw from their savings after retirement.
Good diversification in a mix of different asset classes is the solution and some cash in a portfolio can soften the effect of volatility or even a bear. However, such decisions are best left to professionals. I say diversifying is important, but remember you don’t “balance” away too much reward or “balance” in to too much risk.
Some say to achieve CPI + 7% or more in a low or slow return investing environment – both in SA and offshore – you can’t be too conservative by being underweight in equities, overweight in cash. Prefer investments that offer high dividend yields. Fine. But cash as an asset class doesn’t stop earning a yield when companies suspend dividends, as the Anglo American example reminds us. And some high dividend companies only return marginally more after-tax yield than interest on cash.
Another fact is that high dividend companies aren’t immune to bear markets, whereas some cash in a portfolio is useful when you need it or to buy high dividend companies and others when value presents itself.