Cash Creep The Unwelcome Anchor

Readers of NorthBay biz have likely lived through several economic downturns. As measured by time and loss of production, they’ve varied from mild (mid 1990 to early 1991) to severe (late 2007 to mid 2009). During downturns, you’ll likely hear investment professionals utter the phrase, “Cash is king.” Many financial advisers regard cash as a vital tool in the ongoing management of an investment portfolio. During a correction or deeper bear market, cash will serve as a finely tuned shock absorber, shielding a portfolio from greater levels of downside exposure. But the opposite is also true: During a market rally or extended bull run, cash can quickly take on the form of an unwanted anchor, preventing a portfolio from realizing its full potential.

Throughout a given market cycle, it isn’t uncommon to find an adviser holding cash balances that range anywhere from 10 to 20 percent of a portfolio’s total asset value. Surprisingly, higher cash weightings aren’t always dictated by the fear of a looming downturn in the market. The routine practice of portfolio trims and adjustments can often lead to the gradual accumulation of higher cash balances, otherwise known as “cash creep.” If not monitored frequently, portfolio cash creep can—and will—transition from a short-term, active decision to a long-term portfolio strategy.

There once was a time when cash played a meaningful role in a diversified, multi-asset class portfolio. That role diminished quickly when the global financial crises hit full stride in 2008. In response to the crises at that time, interest rates on cash deposits quickly plummeted to the 0 to 0.25 percent level. Four years later, this rate remains intact with every indication it will continue into 2014. At the high end of this rate range, a $100,000 cash deposit will earn a whopping $250 in annual interest.

When advisers let cash levels drift higher in today’s environment, they essentially place a massive bet (even if indirect) on a short-term market drop. After all, a 0 to 0.25 percent return can only beat negative returns in the market. There simply isn’t room for any other competing positive returns. In anticipation of weakness across areas of the equity market, active portfolio managers often trim or sell positions to reduce market exposure. As these periodic sales occur, cash balances can quickly drift higher and become a more meaningful weighting within the portfolio. Advisers often prefer to “keep the powder dry” for sunnier skies ahead. But what if those blue skies aren’t apparent for six months or even a year? Is cash your only option when riskier, more volatile asset classes fall out of favor?

Although today’s interest rate environment continues to offer historically low yields, the fixed-income market remains wide and diverse. With the assortment of highly liquid, inexpensive fixed-income funds throughout the marketplace, advisers have numerous options for finding better alternatives to cash. At our wealth management firm, we believe that very few circumstances warrant portfolio cash weightings in excess of 5 percent. Barring a client’s specific need for income or near-term expenses, cash should be kept to a minimum throughout all market conditions. The fixed-income universe simply provides too many choices for stable, low-risk yields in excess of what’s currently offered in the cash market. Of course, when cash is minimized in favor of better yield opportunities, advisers should be particularly mindful of credit and interest rate risk. Once again, with the explosion in highly liquid, fixed-income fund options, advisers can keep a steady hand on both risk factors.

A fixed-income holding’s return isn’t limited to its level of interest payments alone. In any given year, bond markets may experience an upward rally that lifts underlying prices. The combination of price appreciation and ongoing interest payment(s) comprises the total return of a given fixed-income product. In some years, this total return figure can be surprisingly favorable. For cash holdings, however, price appreciation is nonexistent. Current yield levels of 0 to 0.25 percent represent the true total return figure for cash.

The last few years provide a good example of when cash creep serves as an unwanted anchor within a portfolio.

In 2012 in particular, fixed-income funds of various types offered a reasonable alternative to cash. Many funds offer low to moderate levels of risk across the credit spectrum. Additionally, some funds combat interest rate risk by holding bonds with shorter maturities. This range is typically five years or less. Many funds are often highly liquid, allowing for a great degree of flexibility when portfolio moves call for an increase or decrease in riskier asset class weightings. Although fixed-income funds aren’t as risk-free as cash, they can offer a substantial reduction in risk as compared to the S&P 500. Simply put, when comparing these options against cash, the incremental return potential far outweighs the marginal increase in risk.

In 2012, fixed-income funds didn’t experience the panic-based rally they enjoyed in 2011. In this sense, a year like 2012 could be considered normal in the fixed-income market where the asset class didn’t experience an unusual rally or decline. If you consult 2012 return figures, they’ll help illustrate the importance of keeping minimal cash in a managed portfolio. Make no mistake—the underlying holdings within any given fund can certainly lose value. But with careful management of the risk factors mentioned in this article, an adviser should be able find a reasonable alternative to nonexistent return levels in today’s cash market.

It’s important to monitor portfolio cash balances on a regular basis. Can you quickly determine your portfolio’s total cash weighting? Is there a percentage figure you consistently see on your statement month in and month out? Your weighting may very well consistently sit in the 10 to 15 percent range. Reach out to your adviser to better understand this strategy. You may find your portfolio has been dragging an unwelcome anchor for an unusually long period of time.