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CIARAN RYAN: How much cash should you be holding in your portfolio? Cash allocations are typically held either to manage volatility or as a war chest to seize market opportunities that present themselves. In the context of wealth management, cash provides for income requirements or emergency funds. It can also create valuable breathing space for growth assets.
The cash debate is a great example of how advisors provide value to clients, although it’s not always easy to decide whether to invest in cash or not. For long-term investors, all the evidence suggests that investing in cash and cash equivalents is often the best choice. Integrating cash solutions into an investment portfolio provides stability, flexibility, and risk management – enhancing the resilience and effectiveness of the overall investment strategy.
But what are some of the risks in fixed-income markets, and what should investors keep in mind when choosing a low-risk investment product?
To answer these questions, we are joined once again by Adriaan Pask, chief investment officer at PSG Wealth. Hi, Adriaan.
This topic of cash and how much you should hold in your portfolio is a never-ending debate, isn’t it? Of course, it depends very much on where the market is in its cycle. Can you explain the purpose of holding cash? I guess there could be many reasons for that.
ADRIAAN PASK: Right, Ciaran, and thanks for having me. From our perspective, the purpose of cash, if you look at it from a portfolio management context, involves two approaches.
On the one end, you might use cash to reduce volatility in the portfolio. Even some of the more conservative fixed-income asset classes still exhibit some meaningful levels of volatility over time.
If we think back to what happened with our bonds, for example when rates started moving up, we still witnessed significant capital losses. So, the coupons are moving higher, but you also see immediate capital moves down on your principal, whereas in the case of cash, the yields are typically quite low. So you’ve got to be careful, especially if you hold onto it for longer periods because you’re not beating inflation by the time that you subtract management fees and consider taxes and other important factors.
Cash is one of the few very stable asset classes that you can deploy in a portfolio, especially for the more conservative portfolio managers; it has a useful purpose. Obviously, currently, interest rates are typically a bit higher, so there’s value and the opportunity cost is seen as a bit less, but I think first and foremost it is a good counterbalance to mitigate any volatility.
The other useful thing, perhaps more so from the standpoint of a multi-asset manager, is similar to that of a typical balanced fund or even equity managers who occasionally deploy a little bit more cash in their portfolios or who are content to bank profits in the stock market and possibly retain a small amount of cash – usually with the intention of using it to take advantage of opportunities.
That’s useful in an environment that’s typically quite flat where returns aren’t necessarily moving forward; but at the same time, there’s still a lot of volatility that you can make use of, potentially being a little more active in the portfolio. But for you to do that, it helps to have a little bit of additional cash on hand.
And next year that is something completely different in the wealth-management context, where I am. I’m an asset manager in a wealth-management business.
But what we see wealth managers do with cash is that they need to provide for clients’ short-term cash needs, but also manage investor behaviour.
I think that’s one of the most valuable areas to deploy cash in a financial planning strategy, because what we’ve done on our side is create some breathing space for the growth assets to do what they’re supposed to do.
For example, instead of deploying for, say, a conservative client or a client seeking stable growth, you could typically go into a stable mandate or a preserver-type mandate. The alternative is to look at the cash requirements or cash flow requirements of a client.
Say, for example, they need some money to pay for a holiday or school fees and over the likes in the next 12 to 24 months. You would provide for that in a money-market portfolio, which reduces the stress even on a stable fund, although conservative. Typically, these still consist one-third of equities and you don’t want to take money out of that if there has been short-term pressure in the market. So even in that case, you can leave that portfolio to do what it’s supposed to do over a minimum period of three years, for example.
This also helps with client behaviour by ensuring they don’t panic when the market downturn occurs since they know their income needs are adequately met in the cash area.
CIARAN RYAN: You talk about that in the PSG Wealth context. What do you offer to your clients in the space of cash and cash management?
ADRIAAN PASK: On the more conservative end of our product set, we have an Enhanced Interest Fund and an Income Fund of Funds solution. But again, we operate a bit differently from the typical asset manager.
If you look at our Enhanced Interest Fund, it’s a money-market type of portfolio, really ultra-conservative. But if we look at our typical financial planning approach, what we would do is say to a client, ‘What are your 12-month needs?’ They would say, ‘Well, I only need an income monthly’. And then they are fine.
Now, if you put that in a money-market portfolio, that portfolio has a limitation in terms of how much duration it can take or the level of interest that it can harness out of money markets. So generally, they can’t invest in longer-dated instruments for higher yields – and that’s just by virtue of money-market regulation.
Let’s assume you ultimately sit with 12 deposits, each maturing at the end of every month for a year. If you were to construct a portfolio of 12 securities, like that with 12 deposits, what would ultimately be the average maturity? That would be 200 days.
But if you look at a money-market fund, it is limited to 90 days. Meaning, for that purpose, a money-market fund is actually excessively conservative. They’re not playing the yield curve far out enough, which means that they are leaving an amount of money or return on the table. And by putting our mandate up for 200 days, we can get a little additional return – hence the name ‘Enhanced Interest’.
But at the same time, by setting up a specific mandate, we could also write into the mandate that we use only investment-grade money-market instruments or investment-grade issuers.
You would think that money markets are compelled to [do] the same thing, but generally they aren’t. They can also invest in other things that aren’t necessarily investment grade.
So looking at those two things you actually see a very good example of how we could enhance returns and at the same time reduce risk, by just deploying the client’s investment or risk budget a little more effectively. So coordination with our partners in the wealth management space is quite useful.
We do similar things in terms of aligning our financial planning philosophy on the wealth-management side with what we offer in our portfolios that our advisors use.
CIARAN RYAN: You mentioned fixed-income products being on the low side of the risk spectrum, but there are some risks, are there not? Maybe just cover that.
ADRIAAN PASK: Yes, risks certainly do exist – I think [that is] generally reasonably misunderstood.
So I think at a basic level you should always ask when you enter into this space if there is something with an enhanced yield, and where that yield comes from. In most cases, I think it could be from duration, so just increasing the duration in the portfolio as I mentioned.
In other cases, it could be from exposing assets to counterparties that are associated with more risk – so going down the issuance rankings and buying into instruments that aren’t necessarily such high quality. That’s something that investors should be aware of, especially in this environment where what we see out there is that investors are chasing yields and not necessarily considering the risks, because the risks are a bit more complex. It’s not like the equity market where everything is approached with a broad brush in terms of equity investing.
In this space the differences in the risks are very meaningful, as you can imagine, from using an instrument that’s issued by one of the big banks, and it’s a secured debt that they issue, and they pay you a yield for using that debt.
In other cases, there might even be private debt. So this is debt that isn’t listed on the JSE, it’s not freely traded, and you might not even have a daily updated market value that’s tested in the market.
Therefore, there are some liquidity constraints and some transparency constraints. There might be issues if you wish to liquidate it if it’s not fully liquid. So [there are] those kinds of risks that you need to understand.
And typically, the way that the average investor approaches risk is to use the very old-school method of looking at return in relation to the volatility of a security.
For us, volatility is not really the risk. I think volatility entices wrong behaviour by clients, and therein lies the risk. However, volatility itself is not necessarily an indicator of risk.
In fact, the most volatile asset class that we use in equities is the growth engine of a client’s portfolio. So you need to understand what the real risks are, and they don’t necessarily exhibit themselves in the volatility of the asset class. In many of those cases, the volatility is quite low because of that same risk that there is no liquidity, they’re not trading, and therefore they have low levels of volatility.
But if you start to look at whether you can trade the paper, then there are liquidity issues and you struggle to get your money back at fair prices.
CIARAN RYAN: So what should investors be considering when choosing a low-risk investment product? If they, for example, feel that the equity market has run too high, is that a chance for them to maybe switch to a fixed-income or a cash product, or are there other reasons to do this?
ADRIAAN PASK: Typically from a financial planning perspective, the work that we do as a wealth manager is to say you shouldn’t be trying to time the market to that extent.
Ideally, your portfolio should be positioned to consist of sufficient cash so that you can meet their short-term liabilities and cash needs, and the rest should just meet your risk profile more broadly.
But if you start to consider that cash component in your portfolio, I think investors are currently looking at it very one-dimensionally in terms of what the yields are, and they’re chasing those yields. But I would add the component of risk, as I’ve mentioned before.
Value for money plays into the space as well, because we know clients are quite cost-sensitive and they are particularly cost-sensitive when it comes to more conservative products with a generally lower return.
I would say you need to seek a solution that is well-balanced across risk, return and value for money, and not just get distracted by the top performers with very high levels of returns. That’s generally paid for in the price of taking on more risk, which is not generally understood.
I’ve mentioned the counterparties and liquidity risks. It should also be mentioned, especially in this environment where we are most likely looking at interest rate cuts coming, that these portfolios are also exposed to an element of reinvestment risk.
In other words, as some of the existing assets on the portfolio start to mature, those assets need to be deployed into the market elsewhere. And as rates come down, typically what you can find offers a lower yield than what you had in the portfolio previously. Therefore, you need to understand to what extent the portfolio is exposed to that kind of risk as well.
But in terms of what investors should consider, ultimately don’t lose sight of your financial-planning goals along the way. Understand where your growth is coming from. Don’t try to be too aggressive in the sleep-easy part of your portfolio, the cash component.
It’s good to try and reduce cost and look for higher yields and optimise things, but know where the line in the sand ultimately lies in terms of your risk appetite.
And if things get too complicated where you are not aware of all the risks, then you’ve most probably gone too far down that spectrum – and the risks are complicated.
So ultimately, if you’re in a position where you’re looking to invest a significant amount of cash, but you’re not necessarily familiar with the various risks that I’ve mentioned, then seek out the help of a wealth manager [who] can give you suitable advice in this environment which is a lot more complicated than is generally believed out there in the market, I would say.
CIARAN RYAN: Alright, we’re going to leave it there. That was Adriaan Pask, chief investment officer at PSG Wealth.
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