Thoughts on Cash Weightings in a Portfolio

I was recently asked in a media interview, “Why has your cash weighting come down recently and what would you say to those investors who worry about the high levels of cash you have carried on occasions? Some argue that they manage their own cash balances in their portfolios and want their managers to focus on their specific asset class”.

Of course I have been asked variations on this question many times over my career, but it is a very important question and not easy to answer in a single shot. It would also be fair to say that my answer has evolved over 10 years, as I have discovered the way my philosophy and investment process interacts with portfolios and markets. So here is an explanation:

  1. The simple reason cash balances have come down is that there are more stocks we want to buy relative to two years ago, and the outlook, market by market, looks better than it did two years ago; I have written at length about this in previous months.
  2. I maintain that the cash position has never been “very high”. I don’t think having 15% cash in a portfolio is very high, though I do think 50% cash in a portfolio would be (and I recognise this is not a ‘consensus’ position). A 15% cash weighting will only dampen performance by 15%, while 50% cash will dampen performance by 50%. There is subjectivity to the assessment, but given high tracking error, active share at 90% and raw daily beta versus the MSCI Emerging Markets Index (GDP) close to 0.6, cash balances need to be very high to prevent one getting a strong expression of active investment management of the asset class, whatever the strategy.
  3. It is worth repeating the second point. The ‘expression’ of emerging markets in this portfolio is different enough from the index or universe that it is highly problematic to talk about our clients managing their level of exposure to the asset class directly; a client’s exposure emerges as a combination of their structural allocation decision and my portfolio construction (even if this were purely stock, sector and country allocation and zero cash). Funnily enough, this is exactly what clients should want if they’re looking for active management; if one wants to have complete control of the asset class exposure, one should use an index fund. This confusion about the necessity of the interaction effect is one of the reasons the active management sector is so weak (most allocators and most active managers will not admit to it).
  4. Related to points 2 and 3, assuming the manager of an active portfolio is attentive and diligent, they stand a better chance of understanding the interaction effect than an external party. Remember, for example, that in April 2015 the model portfolio lost 5% relative performance in a single month to the index in a rising market. At the time, cash balances were at around 15%. However, crucially, if we had been fully invested, our relative performance would not have been better (since we would have owned more of the same badly underperforming stocks) and we would only have increased relative risk (we ended up strongly outperforming the market in a down year). An external asset allocator’s decision (correct from their point of view) would have been to increase their allocation to emerging markets in a rising market. This would only be correct if they did not have an active manager, or if they allocated to an index fund. My response was to bide my time and wait for a better opportunity (as it turned out, February-June 2016).
  5. Contrary to concerns at the time, the 18% cash balance did not become the structural position of an over-cautious perma-bear. The extra 10%-15% cash (whether from inflows or raised from sales) was invested within a two-year time horizon. The pressing concern to keep money invested on a daily basis that is supposed to be invested for a three- to five-year time horizon in an active strategy is part of a failed thought process. It seems perfectly reasonable to me that it might take three or four years to invest some (not all) of an investment allocation that will be held for three to five years, or ideally longer. I suspect that not enough managers have the stomach to argue for this because not enough are convinced about active management.
  6. In emerging markets, unlike some narrower asset classes, I don’t think it is possible to be a very good active manager on a large scale without having strength in macro thinking and asset allocation (whether or not that is one’s primary strategy). For all the merits of bottom-up investing, it is not possible to safely invest in a bank or iron-ore company in emerging markets without a ‘wider view’. Unfortunately, this means that there is a natural affinity between being an active emerging market fund manager and ‘interacting’ with the top-down asset allocation decisions. This is why index investing is easier.

Overall this year, though the model portfolio has lagged a strong market, I am comfortable with how it has fared. Strong outperformance in the first month of the year, when markets were still struggling, is a good baseline to have. Meanwhile our upside capture improved through the year after a weak start, our underperformance for the full year is only the same as the whole of April 2015 (as mentioned above), we are amongst good-quality peers, and the portfolio is full of latent potential (Korea, Turkey, financials) – though naturally not without its risks and opportunity costs.

 

– Edward Lam, Lead Fund Manager, Somerset Capital Management LLP

 

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