Understanding the multiple roles cash has to play in investment portfolios can help investors overcome the often-criticised downside of holding cash. For example, money currently earns very little yield and it remains subject to inflation risk.
For the purpose of this article, I am only referring to cash held within portfolios, and not to other and separate reserves that investors must retain to meet unexpected expenditure.
I’ll start by tackling the shortcomings of holding cash. Of course, in this financially repressive period of low interest rates and mildly positive inflation, cash is indeed costly. Still, we believe that asset allocation decisions should be made through a valuation-driven framework.
Cash provides stability
If valuations of risk assets appear extremely rich, we argue it is better to hold some cash and potentially accept temporary purchasing power erosion from inflation than to hold overvalued assets and risk substantial losses in an attempt to earn a higher portfolio yield.
Cash performs three main roles in portfolio construction. First, and most obvious, is that it provides stability and readily available funds to meet known liabilities, such as regular fixed drawdowns. It therefore avoids the need to sell investments at inopportune times.
Second, holding cash provides defensive diversification benefits. The principle of diversification remains a key building block of effective asset allocation.
The idea that introducing imperfectly correlated assets to a portfolio can both decrease risk and enhance opportunities for return is well established in academic literature and among investment managers.
Serious warnings
Correlations between asset classes, however, change over time. A closer look at historical correlations shows an important trend has emerged and even strengthened: correlations of most risk assets to global equities have increased remarkably over time, as shown by the chart above.
From a portfolio perspective, we think some serious warnings are in order. The fact that these risky asset classes tend to move in tandem with each other, rather than being a counterweight, indicates that the potential for diversification is low.
Central banks can affect sentiment, risk-taking and flow of capital into (and out of) risk assetsDuring the 2008-2009 financial crisis, most asset classes moved in one direction (down) and most short-term correlations strengthened. Spikes in cross-correlations have certainly become more pronounced, exacerbated by risk-on, risk-off trading and high capital mobility.
It is also apparent that central banks have the ability to influence stocks in the short run, alter historical asset class correlations and fuel contagion within them.
By controlling liquidity injections and influencing the rate of return on “safe” government bonds, these monetary institutions can affect sentiment, risk-taking and the flow of capital in (and out) of risk assets.
As a result, asset class diversification, which aims to help mitigate portfolio losses, has tended to fail exactly when it’s needed the most.
‘Dry powder’
Amid this secular rise in correlations, cash and short-term bonds are the only asset classes that have reliably delivered low to negative correlations with risk assets, especially during times of market stress.
There are other defensive assets that can provide low correlation relative to stocks, such as gold. But while gold provides a similar level of diversification as cash, it comes with significantly higher volatility.
A third function for cash is to serve as “dry powder” for opportunistic investment. In order to be successful, we need to be prepared to navigate some pretty choppy waters without losing sight of our long-term objective, which is to protect and grow our clients’ capital.
During periods of market overvaluation, cash allows us to both avoid the negative impact of downturns and take advantage of future opportunities that offer better risk-adjusted returns.
It’s prudent to hold enough cash to commit to situations with exceptional risk/return profilesWhat’s interesting about the three main roles cash has to play in portfolios is how closely they are interlinked. The need for liquidity is often highest when correlations among assets are spiking, diversification is failing and forced deleveraging is occurring.
In these situations, valuations become distorted due to forced selling and investor panic, which can be just the right time to put dry powder to work and acquire assets at discounted valuations.
So, how much cash should a portfolio hold? The answer will vary depending on the objective and risk profile of the portfolio, but consideration for absolute and relative value, expected returns on competing assets (bonds and equities) and market conditions will contribute to the decision-making process.
In the current climate we feel it’s prudent to hold sufficient cash to be able to commit to special situations which are deemed to have exceptional risk versus return profiles should they present themselves.
SOURCE: Ryan Paterson – www.iii.co.uk
Ryan Paterson is research analyst at Thesis Asset Management.
