Cash is insidious, like water. It leaks into portfolios, doing unintended damage. Like water, of course it also has good qualities. But too often the price to be paid for those good qualities is very high, and acceptable substitutes are available at amuch lower price. That's the nub of Russell's dislike for cash in institutional portfolios.
Let's think of the accidental damage first, because so few are aware of its existence, let alone its extent.
The jargon term for cash being found accidentally in portfolios is frictional cash". When equity managers trade securities, they often temporarily hold cash from a sale before it is used to settle a purchase. Or dividends arrive, or contributions to the fund, and they too are temporarily uninvested. They all give rise to frictional cash.
Suppose the equity market returns 15% in a certain year. Suppose cash returns 5% in that year. Then there's a 10% difference between their returns. If 6% of the portfolio represents frictional cash, then the leakage of performance is 6% of 10%, or 60 basis points a year in the equity portfolio. And if the equity portfolio is 75% of the total fund, then the total fund loses 75% of 60 basis points, or 45 basis points a year. Unintended. Insidious. How many millions would an additional 45 basis points a year over the past 10 years have meant to your fund?
In Russell's multi-manager funds, equity managers are told to maintain fully invested portfolios. Any cash in their portfolios is clearly frictional. Every night the custodian sweeps up that cash and covers it by buying the equivalent amount of equity index futures. In that way, the cash earns an equity return rather than a cash return. Over the past 10 years we've looked at our US-based funds in detail. And we found that, with equities typically representing 60% of a total fund (rather than the British 75%), we recaptured 32 basis points a year for our clients. In other words, very close to the numbers I used above.
Of course being fully invested hurts when the equity market is falling. But ask yourself: over the long term, which will have a higher return, equities or cash? Equities, you would assume, otherwise why buy them at all? But what if we could time the markets, equitising cash only in rising markets and not in falling markets? Wouldn't that be perfect? Yes it would. But market records show clearly that the market accelerates most rapidly when it rises from a trough. Unless you anticipate the troughs with precision, you lose much of the long-term equity premium if you miss the earliest part of the rebound. The only way to be sure of capturing it is to be fully invested at all times.
That's why we don't like frictional cash.
WM statistics show roughly 8% of pension fund portfolios consist of cash. Not all is frictional. Some must be strategic.
With pension funds, bonds probably match certain liabilities better than cash, so there's rarely much point to using cash rather than bonds for strategic risk reduction. Instead, the strategic role cash usually plays is that of providing liquidity, making it easy to pay benefits in funds where benefit payments exceed contributions. Again, it's usually much more effective to equitise the cash. Keep it in the fund as backing for equity index futures. In this way you capture an equity return, while leaving it simple to unwind the equitisation and use the cash for benefit payments no earlier than you absolutely have to.
That's one of those little details of day-to-day implementation of investment policy that pay off enormously over the long term.
Don Ezra is director of European consulting at Frank Russell Company"
No comments yet