Ending cash drag with equitisation
Equitisation is a strategy designed to boost returns. It does this by reducing the drag on performance caused by having unnecessary cash in a portfolio – simple but often overlooked.
Having carefully designed a strategy suited to the needs of their fund, many trustees fail to see it implemented efficiently. Over time, small pockets of cash build up in nooks and crannies around the portfolio. (This is different from the cash allocation specified by the trustees in their asset allocation decision.) These small pockets of cash do not earn the returns the trustees need to meet their objectives, causing ‘cash drag’. By finding ways to limit these unintended cash holdings, and by ‘equitising’ any that cannot be avoided, the fund will earn a return much closer to the return deserved by the underlying investment strategy.
Most equitisation strategies are conceptually simple. They operate by monitoring the level of unintended cash that has built up in a portfolio, and by buying futures contracts (or some similar derivative instrument) sufficient to ensure the cash plus the futures contracts performs exactly like the underlying market in which the cash is supposed to be invested. So when the market rises sharply your portfolio is not left behind, slowed by the cash holdings that have built up.
In practice, of course, the process can get quite complex. So long as the portfolio is never leveraged, practitioners often use quite sophisticated derivatives techniques to cover the cash holdings as cheaply as possible. That coverage can extend to multiple equity markets as well as some fixed interest markets. Keeping a continuous track of the cash levels in a portfolio comprised of different fund managers pursuing a variety of strategies is also challenging. Professional fund managers, including the more proficient ‘manager of manager’ firms, commit serious resources to fine-tuning this aspect of their operations.
Cash drag is not just an academic peccadillo. The performance erosion from cash drag can be disconcertingly large. Consider a simple example. Suppose a fund allows as little as 4% of its portfolio to build up as cash in various nooks and crannies. (Many funds would find this to be a low estimate, given most of their fund managers alone probably maintain between 2% and 5% in cash on their behalf.) Assuming a long-term performance differential of 5–6% between cash and shares, the cash drag will ‘cost’ the fund over 0.2% per annum, or over £500,000 a year for a fund of £250m.
Unfortunately cash drag is insidious. It can arise in many ways to surprise the inadvertent. Common examples include where cash accumulates from uninvested contributions, or from dividends not yet reinvested, or where managers build up temporary liquidity buffers in anticipation of cash outflows. In these cases the trustees or their managers are hopefully deliberately balancing between the cost of investing (or disinvesting) immediately and the opportunity cost that is cash drag. Equitising the cash in the interim makes sense here since it reduces the opportunity cost and hence gives you more time. In numerous other cases, though, trustees simply are not aware of the extent of the cash build-up in their portfolios.
A variation on this scenario arises where there is a gap when a fund moves from one manager to another. Larger amounts are typically involved, albeit over a shorter period. Faced with this challenge, many funds have opted to employ a specialist ‘transition manager’ to assist in moving the money seamlessly from one manager to another. In such a case, equitising the cash balances continuously through the transition would be a key part of the service.
Few trustees have the resources or infrastructure to run a full equitisation programme over their fund. That’s one of the reasons that ‘manager of manager’ arrangements have become popular in some quarters. However, there are some things you can do:
q Make sure your mandates specify that all accounts are fully invested;
q Ensure that your SIPs permit use of specified derivatives for the purpose of equitising cash holdings (but not leveraging);
q Co-ordinate cash-flows into and out of the fund to minimise the cash holdings through time;
q Monitor all cash holdings carefully, and calculate the aggregate level of cash across the whole portfolio;
q Ensure there are no gaps during any manager transitions you need to make.
M Scott Donald is director of research, and Adrian Jackson is director of transaction services at Frank Russell Company