by Infocus Author
After ‘Black Monday’, the ASX 200 opened much lower but then rose 209 points during the day to close up +2.72% on Tuesday. Of course nobody can reasonably predict turnarounds like this with any precision but it is not unreasonable for analysts to attempt to distinguish bouts of short-run volatility from a long-run, secular decline. During times like those experienced in the last few weeks, some people question whether a fund, such as ones from the Alpha Funds Management suite, should have held a larger position in cash.
Cash held inside a managed fund should be distinguished from cash held directly in an investor’s say term deposit. The latter can be used for transactions without the costs of drawing down from a fund or, importantly, drawing down from a fund during a downturn. All investors should have some direct cash holding but the amount held depends upon the investor’s specific circumstances. In this note, we will focus on a cash holding within a managed fund. For simplicity, let’s nominate a 30% cash holding.
At the moment cash rates are so low that we can think of the cash rate over a month or so as being effectively zero. That assumption greatly simplifies the maths. If the non-cash part of a fund (let’s call it portfolio ‘A’) returns 2% (capital gains) over a month, ‘A’ combined with 30% cash would earn 0.7×2% = 1.4%. If portfolio ‘A’ combined with 30% cash earned ???2% over the month, the composite portfolio would earn ???1.4%. In other words, cash dampens the composite return towards zero. However, cash holdings also reduce distributions – and a fund that charges fees is implicitly charging for cash holdings.
If the 2% return example in the previous example was accompanied by an intervening short-term fall of say -10% and a bounce-back to still achieve the 2% return on the month, there is no gain or loss unless the fund traded in the dip, or the investor needed to draw-down funds. Assuming that the latter is accounted for by cash holdings outside of the fund, a significant cash holding such as 30% only benefits the investor if the fund invested heavily in the downturn! In other words, a fund with a significant cash holding in volatile times only gains when the investor agrees with a high degree of risk taking. Until the bounce-back has taken place, it is not known how deep the dip will be.
How many conservative or balanced investors would have been happy if they had known a large cash holding was about to be nearly fully invested on ‘Black Monday’ or Tuesday morning? Of course, if there is an expected secular decline in markets, a cash holding might later be drip-fed into riskier assets over a long period of time and therefore, with less risk than in short-run volatility bursts.
Since Alpha Funds Management believed that increased short-term volatility might accompany the actions of the Fed it was not appropriate to go significantly into cash (of course Alpha always holds a small amount of cash consistent with day-to-day management of funds). If, at some point, the Alpha team expects a secular decline in relevant markets, it has the facility to hold higher cash levels and it intends to do so as appropriate.
In a related matter, an advisor pointed out that the May Economic Update canvassed a ‘high’ of 6,400 before the end of 2015. Importantly, that May issue pointed out that the e-o-y forecast was 5,900 but the market was running ahead of the January 1 forecast. The updated e-o-y forecast was stated as 6,100 but, such is the extent of volatility, a ‘possible 6,400’ could not be ruled out as a temporary high – hence the exclamation mark after the 6,400 in the May update!
Followers of our webinar series will note that we published the high and low ASX 200 forecasts from time to time and specifically in the May webinar. The point of the webinar series is to give more information to advisers than we could reasonably expect to get through directly to our investors. We reproduce the May webinar chart below with exactly the same forecasts that we published in May and other months but with the ASX 200 updated to the close of Tuesday 25th August. We feel comfortable that these bounds and forecasts convey useful information to advisers.
In summary, substantial cash holdings to get through short-term periods of volatility is tantamount to encouraging risky trading by a fund manager. Alpha prefers to take long-term positions by choosing appropriate funds, weights and ’tilts’ – but, of course, Alpha reviews all holdings on a regular basis in team meetings and in annual reviews.
Box forecasts of the ASX 200 as at May 2015 but with updated index data
Notes: For each calendar year, the diagonal solid, coloured lines are the baseline forecasts. The upper and lower dotted lines (of the same colour) are the predicted highs and lows for some unspecified point during each year. These forecasts are not altered during the course of the year but updates are calculated and reported on over the year to show whether the original forecasts are still consistent with actual behaviour.
Ron Bewley PhD, FASSA
Woodhall Investment Research