Fulcrum Asset Management
How much cash should a long-term portfolio hold?
By Paul Seaton, Managing Director of Fulcrum Asset Management
At a time when financial markets are volatile and interest rates are rising, cash has greater appeal than it has done for some time. However, while it has a role for capital protection and optionality, it has limitations and there may be better options to enhance the risk/reward characteristics of a portfolio.
After more than a decade where cash returns were at or near zero, in 2022 rising interest rates saw cash rates lift. At the same time, bond and equity markets fell in parallel. The long-duration trade that had supported areas such as technology and long-dated government bonds reversed in a matter of months.
This gives cash a new appeal. As traditional diversification strategies come under strain, cash provides an uncorrelated source of return. When interest rates are higher it provides capital safety in a precarious world. Equally, it brings optionality, some “dry powder” to invest in opportunities as they emerge. Cash rates tend to rise when inflation goes up, which means that cash can actually be an effective inflation hedge, counterintuitively1.
The inverted yield curve is now a reality across many developed markets2. An inverted curve eliminates the risk premium for long-term investments, meaning investors can generate better returns with short-term investments, making it beneficial to hold cash. It means there is no real advantage to holding long-dated bonds.
Despite these short-term attractions, its credentials as a ‘risk-free’ option need to be examined. The real return of cash is uncertain and depends on the macroeconomic environment at any given point. For example, at times of high inflation, savings rates at banks are likely to lag the pace of price rises and investors may lose capital in real terms.
In reality, cash hasn’t offered a positive real return since before the financial crisis. Cash rates have risen, but not as much as interest rates, as evidenced by the significant flows into money market funds. The recent banking turmoil was, in part, triggered by the unwillingness of banks to pass on higher interest rates to customers.
While it may be possible to lock in cash rates for a period of time, cash will need to be rolled over, and the rates are uncertain. As 2022 proved, cash rates are always vulnerable to changes in the macroeconomic environment and that environment can change very quickly. Prior to the war in Ukraine, there was little sense that inflation would become as great a problem as it has become. Inflation rates have proved inherently unpredictable, as has policymakers’ response to them. While cash looks superficially stable, both real and nominal return is variable for long-term investors.
At times of higher inflation, cash and bonds may have greater correlation to each other and investor portfolios can be left vulnerable. This made the case for the inclusion of alternative options.
Cash is certainly part of the mix, but there are also options that deliver some of the characteristics of cash – zero or negative correlation to conventional financial markets, lower volatility and flexibility – without some of its limitations. For example, funds with a cash-plus target can provide diversification but crucially, also seek to deliver a higher return. If they succeed, that 3-5% return will compound over multiple years to deliver a meaningfully superior return to that of cash.
Including diversified alternatives can help provide a specific hedge against inflation, but also against other risks. In blending a variety of specific asset classes, it is possible to manage a broader variety of risks, including stock market volatility, or interest rates, plus rising commodity prices or FX fluctuations. Volatility strategies, for example, will tend to do well when there are large movements in interest rates, as seen in 2022. Harnessing these diverse strategies should give an investment portfolio greater resilience against shifting market conditions.
This may be particularly important today. There is a plausible scenario where interest rates fall before inflation starts to recede. Policymakers may see recession emerging and rein in future rate rises. This would leave cash investors nursing negative real returns on their cash holdings once again.
If alternatives have a low or negative correlation with an investor’s portfolio, they can also reduce the volatility of the overall portfolio, improving the risk/return trade-off.
Chosen judiciously, these assets can be highly liquid, meaning investors get just the same optionality as with cash, but with a higher return in the interim. Incorporating alternatives also allows investors to target specific opportunities and sources of return opportunistically.
Cash has a place, particularly as a short-term tool to create flexibility in a portfolio. However, its characteristics can be replicated by other investments offering more in terms of returns and risk management. Ultimately, a diversified absolute return fund should provide a more nuanced and thoughtful option, with potential for a stronger long-term risk-reward profile.
¹A. Ang “Asset Management: A Systematic Approach to Factor Investing”
²http://www.worldgovernmentbonds.com/inverted-yield-curves/
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