An independent professional's take on the latest news and trends in global financial markets

The conundrum of cash

The current phase of “financial repression” (negative real interest rates that penalise the virtuous while inflation erodes the liabilities of imprudent borrowers)  is creating difficult issues for financial advisers and wealth management firms, many of whom have no experience of living through such an unusual environment. Central to that is the issue of what to do with cash at a time of market uncertainty, when conventional valuation measures are being distorted by the impact which quantitative easing and other monetary policy measures are having on government and corporate bond yields.

Look for example at this interesting report on Trustnet about the way that one of Cazenove Capital’s fund managers is preserving cash in his cautious managed fund, which has a benchmark of beating the CPE by 4% per annum.

Marcus Brookes has defended his 20 per cent cash position in the £707m Cazenove Multi Manager Diversity fund, even though he acknowledges that the UK’s high inflationary environment is set to endure. With the consumer price index (CPI) at 4.5 per cent and base rates at a historic low, cash is losing a substantial percentage of its real value by sitting in the bank. However, Brookes says he has no plans to cut his exposure to money markets any time soon. “Although there is a lot of talk about inflation at the moment, we are even more worried about the government bond market, particularly as a long-term bet,” he explained.

“The fund maintains a third of its assets in equities, a third in either fixed interest or cash, and a third in alternatives, no matter the market environment. We think the potential capital losses in government debt are so high that we’d rather hold cash for the time being.” Although Brookes could invest this 20 per cent in corporate debt, he says this would go against the fund’s risk profile. According to Financial Express data, Cazenove Multi Manager Diversity is one of the least-volatile funds in the IMA Cautious Managed sector over a five-year period.

“We could move into investment grade and high yield corporate debt, but at this point of the economic cycle we think this would increase the risk of the fund,” he said. “A lot of people are saying that the end of QE2 has been priced into the market but we are not so sure. The data coming out of the US has been poor and we anticipate another soft patch. The cash position also keeps our options open when certain areas of the market get cheaper,” he added.

Being prepared to sit on holdings of cash when the market appears to be offering few opportunities  is, as I argued in my most recent FT column, one of the hallmarks of the most successful money managers. The two advantages are: (1) avoiding drawdown during market falls and (2) having the firepower to take advantage of the valuation anomalies that always appear when the market slumps.

To do so requires good judgement and a lot of courage however, since such a stance is easy to criticise if markets remain buoyant.  To do so in an environment where cash is providing negative real returns - and the opportunity cost is therefore higher than normal – makes it an even braver thing for a fund manager or financial adviser to do. However that does not mean it is wrong.

Written by Jonathan Davis

June 15, 2011 at 2:02 PM