“Cash is trash” goes the saying in the market these days. Cash in a bank account yields virtually nothing, and near-cash investment vehicles like money market funds and certificates of deposit offer the prospect of paltry returns. No wonder investors are busy reaching for yield (and grabbing extra risk with that apparent return).
At other times, however, you hear market participants express another sentiment entirely: “Cash is king.”
Complete opposites in their meanings, the two sayings point to the bipolar feelings that many investors have about holding cash. It either depresses them or excites them, depending on the phase of the market. When things are good and most assets are doing well, cash is indeed thought to be trash. But when markets are under pressure and the only thing holding its value is cash, a sizable position in it makes you feel like a king.
The 30-year decline in interest rates has led to today’s skimpy rates on cash and investors’ general aversion to it. During that time, there has also been a big change in how cash is viewed by those who evaluate professional portfolio managers.
I entered the business in 1983. And for the next decade or so, on average, cash in stock mutual funds fluctuated in the neighborhood of 10% of total portfolio assets. Since then, it has plummeted and is now usually in the 3–4% range.
Around the time that this decline started, I was managing portfolios for institutional investors as part of a team that was a “sector rotator.” Basically, a key part of what we did was to try to overweight or underweight the various sectors of the S&P 500 Index, depending on where we thought we were in the economic/market cycle. Part of our marketing message to clients was that “cash is a sector” — that is, we looked at the use of cash as a weapon in our investment strategy to deliver outstanding long-term performance.
But somewhere along the way, it became less common for all types of managers to use cash as a weapon. The decline in yields played a part, and the great bull market created a generation that believed cash was a drag on portfolio return. In addition, there was a significant shift in how clients and gatekeepers (e.g., consultants and advisers) thought about the use of cash, which can be summarized in a comment that became a standard retort from them: “We don’t pay you to manage cash.”
That simplistic view caught on. But a manager with some cash is not “managing cash” but is managing exposure to the investment possibilities available in his or her area of expertise — and investing in a way that takes advantage of cash to capture the opportunities that can generate returns. To limit a manager’s use of cash is to fail to understand the nature of the decision-making process. In any case, if a manager generates good returns with a load of cash that seems heavier than it should be, who cares? The presence of that cash may be one of the key reasons for the outperformance.
Many great portfolio managers have held cash positions that would be viewed as too high by today’s gatekeepers. Some of them just liked having cash around so that when they identified an opportunity, they wouldn’t have to sell something to be able to invest in it. Others let cash build up if they couldn’t find stocks that met their parameters; the cash was simply a residual of their decision-making process. Still others looked at overall market characteristics and adjusted their exposure accordingly, using cash to tailor the risk of their portfolios.
All managers should be held accountable for their performance over a reasonable time frame, and those who run with heavier cash positions should be judged on whether their stated use of cash actually contributes to an attractive performance profile. Those kinds of evaluations require careful consideration of how value is added, which is much more challenging than merely deciding that a certain level of cash in a portfolio is “too high.”
But many gatekeepers revert to the latter approach, saying that it is their job to allocate assets and a manager’s job to manage them within certain confines. Lost in that approach is the information about a particular asset class that the person closest to it can see (and use to improve performance). Cash is not a typical asset class for allocating, and managers should not be hamstrung in their effective use of it.
This past 19 October was the 25th anniversary of the Black Monday stock market crash. Some managers used the volatility of that period to add shares in notable companies at rock-bottom prices. Their ability to do so made their clients a great deal of money — and they would not have been able to capture those opportunities had they been limited in the cash that was available to them.
So, cash is not trash, even when it seems to be. It has real value, a point made in a recent Globe and Mail article concerning what Warren Buffett thinks about cash. As with many other aspects of investing, Buffett challenges the industry norms. According to his biographer, Alice Schroeder, “Mr. Buffett [believes that] cash is not just an asset class that is returning next to nothing. It is a call option that can be priced. When he thinks that option is cheap, relative to the ability of cash to buy assets, he is willing to put up with super-low interest rates.”
That’s the kind of analysis that should be brought to the discussion of cash, not simple sayings that bounce back and forth in response to the mood of the market. Individual investors should not be afraid to hold cash, even when it’s earning little, if it’s available to them when needed most. And investment professionals should get away from misguided notions about how much cash is too much cash in a portfolio. Let the manager use the value and power of cash to execute a strategy. Then you can judge whether the strategy makes sense. Don’t remove cash as an effective weapon.
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