Many investment professionals argue that ‘time in the market rather than timing the market’ is what reaps long-term rewards. As a result, they are reluctant to increase cash holdings in times of volatility. Other advisers take the view that, while cash won't lose you money, it also won’t make you any, so encourage clients to stay in the market at all times. But what if you are pretty certain that market conditions are going to be volatile? Is it really worth staying invested in asset classes that have a greater chance of loss?
The first thing to consider is what level of temporary cash you should have in your investment portfolio. This is separate from the cash worth roughly three to six months of expenditure that everyone should hold in easy-access accounts to cover emergencies such as being made redundant.
The level of temporary cash you hold in your investment portfolio largely depends on whether you should take profits, and hold cash until the volatility or bear market has passed. Moving into cash over short periods when markets are likely to fall, and reinvesting when the green shoots of recovery appear, should substantially reduce your losses and protect the value of your capital. Getting the timing exactly right on this is next to impossible, but if you are only slightly late in selling and reinvesting you could still protect the portfolio from severe losses and partake in any recovery.
Implementing a short-term cash strategy can also enable investors to take advantage of valuation gaps in markets. For example, you could sell out of one market where the bull run has ended, and hold the proceeds in cash until valuation opportunities appear in another geography or asset class. But getting this call right is also difficult.
However, this doesn't stop managers of multi-asset funds from trying to do this. Bank of America Merrill Lynch's most recent monthly survey of fund managers' allocations found that the average level of cash in their portfolios was 4.8 per cent, and a month earlier was even higher at 5.1 per cent. The survey also found that increasing cash was one of the more popular trades in the latter part of 2018.
Wealth managers, meanwhile, had an average cash position of 5.2 per cent at the start of October, according to Asset Allocator, Investors Chronicle's sister publication.
Simon Clements at Liontrust Asset Management, says he moved the funds he runs to overweight cash positions relative to the Defaqto Balanced risk profile in November, after taking profits on assets that did well during 2017 and 2018. For example, Liontrust Sustainable Future Managed (GB00B8FDBQ23), a medium-risk multi-asset fund, had a cash level of 7.5 per cent at the end of November.
“We saw significant risks on the horizon,” he explains. “We don’t like to trade or do tactical (short-term) asset allocation too often, but we will do it if we see opportunities to protect, and it has worked quite well. Cash doesn’t yield much and over long periods you’re better off invested in equities, but after the longest up-cycle in recent history we took the opportunity."
He appreciates the arguments in favour of always remaining invested, but because the market has risen so much, having an overweight to cash seems prudent.
“If you’re a long-term investor, you’re better off holding high-quality companies that can deliver earnings and returns over time instead of cash, which will never get you anywhere," says Mr Clements. "But after periods of strong performance when there are risks on the horizon, moving to cash can be a good way to bank profits and potentially avoid downside during difficult economic times. Holding cash between taking profits and waiting for the next good opportunity is good management, but you shouldn't try to trade it too often as it’s difficult to get right. You also need to be prudent and patient with cash.”
Fear of missing out
Other investors are less keen on doing this because selling out of the market and buying in at the right time is very difficult, and it is likely that you will miss the start of the next bull market, which is often the most exciting and financially rewarding time to invest. Looking at how basic investment portfolios respond to this strategy demonstrates this.
Portfolio 1 is a 60/40 split between global equities and global bonds, as measured by the MSCI All Country World and Bloomberg Barclays Global Aggregate indices. Portfolio 2 has 40 per cent in each of equities and bonds, and 20 per cent in cash.
During the last substantial recession and bear market, MSCI AC World index fell 30 per cent between 3 September 2008 and 9 March 2009. During this period Portfolio 1 would have fallen 5.4 per cent and Portfolio 2 would have returned 0.8 per cent. The addition of cash at the expense of equities would have helped to mitigate losses.
Over the six months following 9 March 2009 MSCI AC World index rose 37 per cent as the recovery bull market started. But you would have been incredibly lucky if you had decided to sell equities and add cash on 3 September 2008, and reinvest the cash in equities on 9 March 2009. It is far more likely that you would have made both trades late.
If you shift the start and end points by six weeks to 14 October 2008 and 22 April 2009, over this period MSCI AC World index returned 3.6 per cent, Portfolio 1 would have returned 14.5 per cent and Portfolio 2 would have returned 13.3 per cent. This shows that over a different period selling out of the market and holding cash would have had a negative impact on portfolio returns. So unless you are very good at timing the market, selling out of risk assets and moving into cash could have a detrimental effect on your returns.
But if you sell out of equities that you think have reached their peak, you do not have to reinvest in cash. You could, for example, invest in equities in a different geographic region or another asset class. Scott Spencer, co-manager of the BMO Global Asset Management multi-manager funds, says they are currently over-weight cash relative to the average level in funds in the Investment Association Mixed Investment 40-85% Shares sector. But he intends to invest this cash as soon as possible.
“We think rising volatility creates opportunities, so are looking for the right ones," he explains. "The cash level might come down and we might increase the alternatives exposure in the funds.”
He also thinks Asian and emerging markets equities might be good areas to reinvest in because their bear market began earlier in 2018 than those of other regions such as the US, where turbulence began towards the end of last year. Mr Spencer says that his funds already have some exposure to Asia, emerging markets and Japan, and if he finds the right managers to invest with he will increase the allocations to these areas. "We’re always looking for opportunities so the cash level will vary,” he adds.
Funds' exposure to cash
Investors running a portfolio of funds rather than direct shareholdings have an additional factor to consider. The managers of the funds may also take time out of the markets they invest in to mitigate downside and/or when they have taken profits. So if you do the same, your portfolio could end up with a greater exposure to cash than you intended.
This is particularly the case in the current investment environment. At the end of 2018, the average cash allocation was 2.3 per cent in US equity funds, 3.1 per cent in UK equity funds, 2.6 per cent in European equity funds and 1.6 per cent in Japan equity funds, according to research company Morningstar.
This suggests that managers who invest in potentially more volatile equity markets such as the US, UK and Europe are trying to mitigate this via cash allocations. So before you make such a move always check the cash position of the funds you hold.
When to reinvest
If you turn to cash for downside protection, one of the most important decisions you need to make is when to buy back into markets. As shown with Portfolios 1 and 2, delaying this decision for too long can hamper returns, but going in too early negates the benefits of holding cash. However, Mr Clements says there are some ways to try to navigate the current bout of volatility.
“What we need to see is a positive outcome from the trade war – some sort of agreement and solution that could spur the final leg of this economic cycle," he says. "On average, equity markets fall 20 per cent going into recession. Over the past year they have fallen around 15 per cent, so if we saw another 10 per cent come off equity markets we would consider that a bad scenario is reflected in prices. That is what we’re looking out for over the first quarter of this year. We would then look for shoots of recovery and [indications of] when the economy will start to improve. We wouldn’t deploy cash until we had a good feeling about that.”
