I have recently spoken to a number of clients who have queried the cash levels within portfolios.
Since March 2009, when interest rates fell to 0.5%, we have been encouraging clients to invest surplus cash, yet we hold up to 20% in cash within portfolios at the moment with interest rates now just 0.25%.
Worse than not earning anything (or very little), cash within portfolios is subject to Equilibrium and Nucleus charges.
I can understand why this has been confusing for clients. However, even when earning nothing and being subject to charges, cash can be our best performing investment if we are able to act quickly.
Cash doesn’t fall in value (at least not in nominal terms). This means it is uncorrelated to other asset classes which is very important during periods of market volatility.
Following the Brexit vote we removed all property from portfolios. This was due to concerns over liquidity and prospects for growth. The UK economy may do very well outside of the EU, but in the short term we were unsure about the exact implications of Brexit and the decision to remove property proved to be the correct one. Immediately following the vote property fund values fell and many funds closed for redemptions.
With no property, and if we were not to hold cash, we would be limited to just fixed interest and equity (plus equity derivatives such as alternative equity and defined returns). Compared to our long term position we are underweight in both these asset classes. We don’t necessarily expect negative returns over the next 18 months, but we wouldn’t choose to increase exposure to either asset class at present. Fixed interest yields are directly linked to interest on cash and therefore at historic lows. The UK equity market is priced at its highest level since 2002 compared to company earnings.
Although in the short term holding cash generates nothing, perversely it was one of our best performing investments last year.
We placed 5 volatility trades between June 2015 and March 2016, buying into the market at lows then selling as it recovered. Though for much of the year the funds were held in cash overall these trades generated 14.9%. Whilst this growth from volatility trades did not directly correlate to the overall growth percentage for our portfolios across the same time period, these trades played a part in delivering positive portfolio returns. In comparison, over the same period the MSCI World generated 3.46% while the FTSE 100 lost 3.50%:
Markets have rallied strongly since the initial wobble following the Brexit vote and for the last few months have been almost eerily stable. At some point this will change. Every single year since 2005 has seen a 10% drop in markets at some point during the year. This is normal market volatility, as shown in the chart below:
A typical 10% fall from the recent FTSE 100 high of 6,955 would mean a drop to 6,260. We have set a trigger point to buy in at 6,350, investing 3% in a volatility trade. An additional 3-5% will be invested if we see a further drop to 6000.
Markets move fast. Having the money sat in cash allows us to place these trades and have the money in the market on the same day as the decision is made, or at worst within 24 hours.
Over the last 5 years the average time for a 10% drop to occur has been 7 working days.
We could place the money in other low risk, low return investments, such as short dated government bonds that would provide low volatility but better returns than cash. However, this would mean that when we want to react we would need to sell the existing investment, then wait 5 days for the cash to clear before we could use the proceeds. The ability to react fast would be lost, and perhaps too the opportunity.
I have also been asked “why don’t we return the cash to clients when it is not being invested?” - I think the reasons above provide some justification for the current position, but there is another reason too.
We have around 900 clients, all with at least 1 and typically 2 or 3 accounts. Returning cash to everybody at the same time would be a huge task in terms of administration. In some cases it would be further complicated where assets are held in pensions or other wrappers where there are tax implications for withdrawals.
When we decide it is the right time to reinvest we would then need all 900 clients to transfer the money back to the investment platform, urgently. At best (assuming no one is on holiday and everyone picks up emails that day) this would take 5 working days ignoring the requirement and monumental task of collating recommendation reports for 900 cash investments all at the same time!
We have tried to eliminate bias in all aspects of our service. The FCA have banned commission which has been a good thing for the industry and for clients, removing bias towards particular contracts or providers.
Equilibrium do not apply transaction charges, as these too provide an incentive to trade regardless of whether it is in the interests of the client.
Some clients have suggested that we do not charge fees on cash within portfolios. I understand the logic behind this, however this introduces bias too. If holding cash meant that company revenue was significantly reduced there would be an incentive to keep funds invested at all times, regardless of whether it was the right thing to do for clients.
Even as things stand, the easy option would be to invest the money that is currently sat in cash. This would instantly remove the difficult conversations about cash reserves. But the easy option is often not the right one.
We have already taken advantage of one opportunity, buying back Kames Property Income at around 3.5% below where we sold it. Our balanced model currently holds 12% in cash. At present the plan for this money is as follows:
- 3% volatility trade at 6,350
- 5% volatility trade at 6,000
- 3% defined return purchase at 6,350This leaves 1% unallocated cash.
With equity and bonds looking expensive we are looking at alternatives like infrastructure investments. Further information is likely to follow from Mike and the investment team in due course.
We may be wrong. Unfortunately with investments there are no guarantees. If markets defy gravity and continue to go up then the cash will be a drag on performance, however many of our clients are happy to forgo some upside in exchange for additional downside protection. Good investment management is about avoiding losses just as much as making gains.
The reality is that market volatility is part and parcel of investing. At some point markets will fall and the flexibility provided by this cash reserve will mean that rather than being a victim of this volatility, we are able to take advantage of it.