Even in the midst of a tumultuous 2020, holding cash creates a significant drag on overall portfolio returns.
2020 has been a tough year for investors. Equity markets staged one of the sharpest sell offs and subsequent recoveries in history, both driven by events not seen in a generation: a sell-off from a global pandemic, and a recovery driven by massive, coordinated global stimulus. This has left many investors unconvinced this rally can hold and some investors are worried the worst is yet to come. The world is certainly not devoid of risk – the COVID-19 pandemic, U.S. politics, trade tensions, and Brexit are all legitimate concerns. So understandably many clients have been refrained from fully participating in markets this year.
In Asia we’ve seen cash balances among client portfolios rise to new highs, more than doubling from their historical average. However, now is also a historically bad time to be holding excess cash in a portfolio. Real rates of return (the yield minus inflation) are negative and near historic lows in large parts of the developed markets, meaning holding cash creates a significant drag on overall portfolio returns. While there is certainly a role for cash, we want to tackle some common investor concerns and provide suggestions for how clients can achieve investment goals while reducing the negative return of excess cash.
Among our conversations with clients we broadly encounter three different rationales for holding excess cash beyond their cash needs: (1) the first group are broadly concerned about the myriad of risks – geopolitical, virus, etc. – and want to hold extra dry powder to capitalize on a sell-off; 2) the second group reduced market exposure when the pandemic struck but missed the rapid recovery and now feel like markets are fully priced and don’t know where to deploy their excess cash; (3) the third group are more concerned about capital preservation and see cash as one of the few remaining safe havens. Of course, most clients will share a combination of all three sentiments. In the note below we’ll address all three concerns and offer suggestions for how investors can improve their returns without compromising on their goals.
(Don’t) time the correction
One of the most common line of thinking, is that ‘a correction is coming’. After all, the global economy is not yet out of the woods and debt levels have reached new highs. Many clients prefer to hold on to dry powder with the expectation of capitalizing on a sell-off. .And the amount of available opportunities in each local markets will certainly differ as well. But from the perspective of the global economy, there are three two forces working against such a strategy in the next 12 months.
First, what the past few years have taught us, is that these event risks are very hard to get right. Take the 2016 U.S presidential election as an example; contrary to consensus expectations of downward pressure on equities markets (after selling off for a few hours of trading, markets rallied, almost without interruption, for a year. Most market participants were caught off guard, by not only the election results, but also the market reaction to the election. The rise of machine trading and elevated volatilities also add to the challenge of market timing in the next few months.
By missing some of the market’s best days, investors can lose out on critical opportunities to grow their portfolios, with devastating results. Over the past twenty years, seven of the ten best days occurred within fifteen days of the ten worst days. This is important because fear may push investors out of the market during bouts of volatility, causing them to miss the rebound on the other side. Chart 1 below shows the impact of missing the best day over a 20 year period, missing only the 10 best days over a 20 year period significantly erodes a portfolio’s long-term return. Trying to time a sell-off can have a large detrimental impact over longer-term returns.
Performance of a $10,000 investment in the S&P 500 between September 30, 2000 and September 30, 2020
Monetary conditions are very stimulative across developed markets
Instead, there are a number of ways to monetize from higher volatility or even further downside in the market. Instead of stocking cash and waiting for (and perhaps, missing) a correction, you can use structured products that can either benefit from higher volatility, enter the market at an outright discount, or help you accumulate positions only when the target security hits a lower price.
Leverage can also play an important role. With borrowing rates as low as they are, clients no longer need to sit on excess cash so they have ammunition to deploy in a sell-off, nowadays it makes sense for clients to borrow as a means for taking advantage of any opportunities that arise.
Confronting high valuations
Across developed markets, major indices have fully recovered and exceeded their pre-COVID levels. In equities, this is mostly led by the Technology sectors, as many investors have sought refuge in the tech sector’s resilience to COVID-19 and strong growth potential. Meanwhile core bond yields are now at historical low levels. As a results clients are getting worried about valuations. To some extent, we share the same concern. But rather than reducing exposure in an outright manner, we prefer adding to sectors that have lagged. The reasons are twofold. Firstly, as mentioned earlier, in the current market environment, the outperformers can stay expensive for a long time. Secondly, from a secular perspective, the technology sector has many of the growth drivers for the next 10-20 years, so it makes sense to maintain a healthy exposure.
Other than tech, it’s time to add exposure to cyclical sectors;
But for returns, we recommend adding exposure to cyclical assets. With the sharp growth contraction behind us, the U.S. economy is on track for a cyclical recovery in 2021. This favors sectors like industrials. We also like infrastructure as a theme having recently launched a New Infrastructure Basket to capture the growth opportunities in China’s infrastructure spending over the next few years, like 5G, artificial intelligence and big data. In addition, we also continue to like consumer discretionary and technology in China – where we think valuations are still more reasonable.
In the bond space, we think there is value in Chinese government bonds (CGBs) given attractive interest rate differential vs. developed markets as well as lower volatility. We also see value in high yield bonds, both in the U.S. as well as Asia. We have quite a few managed solutions on our platform.
Where are the safe havens?
After a decade of quantitative easing across developed markets, safe haven assets are increasingly losing their appeal. The last few months have made this issue crystal clear, with developed market government bond yield falling to record low levels. Positive correlation between core bonds and equity markets have also re-asserted themselves from time to time.
This presents two problems for investors. Firstly, the problem of looking for other safe haven assets that can serve as protection for risk assets decline. Secondly, as a large part of the core bond universe in developed markets are now close to zero-yielding in nominal terms (and negative after adjusting for inflation), increasingly investors no longer get paid to add protection to their portfolio, instead they will have to pay for that protection.
Ultra-low interest rate environment calls for creative ways to find yield;
These challenges mean that a passive approach to investing will see many clients’ portfolio drifting further away from their required or targeted returns over time. So what can we do?
Broadly, we think there are two approaches. Firstly, for some investors, it makes sense to make more active investment in higher income, higher risk assets. In the fixed income space, investors can use short duration, high quality bonds as proxies for treasuries, as they similarly offer protection amid market volatility and liquidity required to take advantage of opportunities.
Secondly, the current environment calls for a broader definition of the concept safe haven assets beyond cash and core bonds. We are looking for assets that meet three criteria, 1) help investors stay solvent in a market downturn; 2) provide reasonably stable cash flows; and 3) have positive inflation-adjusted returns. There is no ‘perfect’ safe haven asset, so investors will need to pick and choose the characteristic that matters to them the most.
- Real assets: such as real estate or infrastructure that provide stable income to hedge against inflation. But their liquidity may be less than optimal for some.
- Private equity: private equity gives investors exposure to secular growth themes that are more resilient to economic cycles as well as short term market volatilities, such as digitalization, healthcare and sustainability. While secondary market valuations may already be high, investors with a longer horizon should consider exposure through private equity investment. Again, liquidity may be less than optimal for some.
- Gold still has some inflation-protection feature and ability to protect against all kinds of tail events – its correlation with equity is not always negative, however. In addition, it does not generate income return (although it can certainly appreciate in value).
- Core bonds: Despite their more paltry returns, core bonds can still play a role due to protect investors against market downturns (most of the time). Liquidity is also much better. We have a number of products on our platform, such as income funds or short duration bond fund.
- FX: Investors can turn to customized derivatives of FX pairs to generate higher returns, and also use FX options to hedge broader risks. In addition, where possible you can use dual currency notes (DCN) can help boost the return.
It’s been a volatile year for financial markets, and also one that continues to look fraught with risks – from the ongoing COVID pandemic, to geopolitics. The upcoming U.S. presidential election is also a big event risk. Understandably, many clients are not participating as much as they normally do, and are holding more excess cash than ever before. We encounter a mix of client concerns in conversations, to risks of ‘correction’, to the lack of worthwhile investment opportunities, as well as the need for alternative safe haven assets. In this note, we try to address these concerns.
We recommend, 1) using structured protect and leverage more pro-actively to capitalize on corrections, 2) adding to non-tech exposure in the US equity market and also adding exposure to China equities (our preferred sectors are technology, consumer discretionary, industrial, new infrastructure), we also like China Central Government Bonds (CGB) and high yield bonds in both U.S. and Asia, 3) replacing some of your excess cash with non-traditional assets such as real estate, infrastructure, gold, and FX to add diversification and yields