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 May 2006 The Case for Cash
Perhaps there may be one. If the mutual fund is an "asset allocation" fund, one that invests in a broad range of assets, then that may be exactly what it should do. Funds like this work well as core holdings since their managers have broad leeway to move around market conditions dictate. When both stocks and bonds struggle (as was the case in 1994), cash may be the best short-term alternative. Managers who correctly make this call are entitled to their compensation. But most investors choose their own asset allocations. They buy funds with specific objectives and styles (e.g. large cap growth or intermediate government bonds) and hire managers with similar expertise. They make the cash/stock/bond decisions themselves, and allocate their funds accordingly. Each fund or manager is chosen to fill a particular niche in Morningstar's stylebox. Cash isn't one of the niches.
The Problem with Gaming Yet the easiest way to beat a benchmark is to invest in assets outside of it. That's why in the recent equity bear market the best performing stock funds were invested overseas, in bonds, cash, or a combination of each. The one thing they were light on was domestic equities. Managers are rated on how often and consistently they beat their assigned index. As a result, there's a constant incentive to game it (see The Name Doesn't Tell It All). That's good for them, but terrible for your asset allocation. A number of studies have demonstrated that the majority of gains occur in just a handful of trading days. If your fund or manager happens to be gaming the benchmark on those days, your portfolio suffers. Most managers think they're smart enough to discern when a major market shift is about to occur. Many probably are, but if they're holding foreign stocks or even bonds when a sudden domestic equity run-up occurs, they're likely to be taken by surprise. Even if they make a timely call, they may still lack the liquidity to take advantage of it. That's why you generally want your funds or managers to stick within the boundaries of their specific investment style. It doesn't do you any good to come up with the world's best asset allocation if your actual investments don't align with it.
The Problem with Not Gaming Here again, successful market timing would be the preferred route, but it's difficult -- if not impossible to pull off -- and limited liquidity only adds to the problem. So it looks like a true asset allocation approach is destined to fail. If the market moves against you, pure style managers will stick within their benchmarks and buy loss after loss. If they try to avoid this fate by gaming the benchmark, they run the risk of missing powerful recoveries within their very sectors. Either the asset allocation or portfolio return suffers. Perhaps they both do.
That's not a very pretty picture. Even indexing won't solve the problem since it guarantees you'll participate in the losses of underperforming sectors within your asset allocation. Are broad market "asset allocation" managers and funds the only viable alternative?
Theory and Practice Unless you're extremely wealthy, sharp or prolonged losses probably make you uneasy. That's why we found in looking for The Best Asset Allocation that investors aren't really risk averse, they're loss averse. Everyone loves risk when it works in their favor, bringing outsize gains. Yet no one is a risk fan when riskier assets suffer sharper losses than more conservative alternatives. As a concept, asset allocation works well in theory. Most investors easily grasp the notion of reducing risk through diversification. They also like the idea of not putting all their investment eggs into one basket. Using different funds or managers to fill the various slots in the Morningstar stylebox makes intuitive sense. But when this same asset allocation leads to short-term losses, they have to be resold on the concept. What's the value in consistently being true to a style if it's a losing style? As we've seen, attempting to blunt these losses by utilizing other investments offers no guarantee of success and may indeed harm your portfolio's performance if the downtrodden sector jumps unexpectedly. Reduced liquidity only exacerbates the potential problem. But holding cash might not. That's right, cash might be the answer. It doesn't matter what niche your fund or manager is populating, if it's out of favor and falling, cash will certainly be the better performer. There's no need to buy a loss for the sake of style purity. In addition, cash doesn't have the liquidity problems of stocks or bonds. If a manager or fund mixed cash along with investments within their specific style, he or she could quickly add to existing investments, even if the market moved suddenly. Finally, cash isn't an asset category like large cap growth or intermediate government fixed income. It doesn't appear in any stylebox. Although a broadened use of cash may temporarily alter the asset allocation (see Mutual Cash), the correct mix can quickly be re-established without risk of loss or undue expense. When you think about it, if an entire asset class is falling, the best thing a manager can do is raise cash. Hunkering down in safer areas may reduce losses, but they're still losses. Moving to cash improves returns on an absolute basis, not just relative. So maybe we shouldn't be so rigid with our managers and funds. Perhaps a best alternative is to tolerate each -- no matter what the stated investment objective -- to increase cash holdings when market conditions dictate. In allowing this, you would be paying management fees for cash, but that's probably not the best way to view it. Instead, it's more appropriate to consider it paying for the manager's prescient decision to preserve your principal rather than risk it in a down market. In that case, cash is the best investment alternative. Although cash decisions at the manager level run counter to a strict asset allocation, you have to ask yourself, "Why are you relying on asset allocation in the first place?" It's probably to maximize (or at least increase) overall return. When a manager's segment of the market is in decline, cash is the best means to this end. Don't fault your manager for doing what's in your best interest. Search this site! Just enter you key word or words:
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HEN YOU BUY A MUTUAL FUND or hire a money manager you expect them to invest your money according to the fund objective or your direction. You don't expect them to hold your cash -- and charge you a fee for it. What would be the point?
