Short-term park­ing

Di­ver­si­fi­ca­tion can in­clude cash – for a while

Finweek English Edition - - Money Clinic - JANET HUGO jhugo@hugo­cap­i­tal.com

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.

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