Cash is still king for investors

The grim days of the global financial crisis may have passed, but, as Benjamin Levy reports, there is sufficient uncertainty about sovereign debt and the pace of economic recovery to ensure cash remains a popular safe haven.

Cash has been a perennial safe haven in times of crisis. Thus there were few raised eyebrows when the global financial crisis (GFC) gave rise to the launch of numerous new cash-based products.

Cash products became fashionable as frightened investors poured their funds into cash funds, bank deposits and fixed income.

At the height of the crisis, self-managed superannuation fund (SMSF) investors were holding nearly 29 per cent of their assets in cash during the two years to 2009.

With sovereign debt issues in Europe continuing to challenge the strength of the recovery and with rising interest rates boosting returns, cash is maintaining its popularity among some investors beyond the end of the GFC.

But some of the more complicated cash products are not proving as popular as investors flood to more liquid investments, while the question of asset allocation and how to use cash holdings is becoming a pressing question.

Cash popularity here to stay?

Despite the market recovering since the lows of the GFC, cash remains popular among investors. According to figures provided by Colonial First State’s (CFS’s) head of investment market research, Stephen Halmarick, investors were holding $1.36 trillion in cash assets — or approximately 12 per cent of total assets — at the end of the March quarter this year.

While this has declined from the highs of the GFC, Halmarick says a reduced risk appetite and the consequent popularity of cash assets is a theme that is likely to remain in place for “quite some time”.

Halmarick also believes that rising interest rates are fuelling a steady interest in cash.

“Some of the returns available on cash rates are pretty attractive since the Reserve Bank of Australia has been raising interest rates, so I think that is sort of a key thing for markets,” he says.

CFS’s own cash deposit product, introduced last year on to its FirstChoice platform, has had steady inflows, Halmarick says.

Fiducian investment manager Conrad Burge says the need for cash assets in any market environment hasn’t changed.

“If cash is doing well, it’s an indication that the economic and financial environment is difficult and testing. Now ... over the last four years or so, cash for Australian investors has outperformed all the growth asset sectors — Australian shares, international shares, even emerging markets, property securities — outperformed the whole lot for a reasonably extended period.

"So obviously [it’s a] difficult situation and people are concerned and want to protect their capital — and cash is seen as a way to do it.”

Some dealer groups are capitalising on the cash sector’s popularity. Independent dealer group Professional Investment Services (PIS) signed a joint venture agreement with an unnamed banking licensee, believed to be Credit Union Australia, in March this year, with plans to launch a cash management account followed by term deposits.

PIS chief executive Robbie Bennetts said the move by a financial services licensee would revolutionise the advice industry, and the model was a way for dealer groups to survive in the future.

SMSF investors are also comfortable remaining in cash, with a UBank survey of customers in March revealing that a third of SMSFs have more than 50 per cent of their funds in cash, with no plans to alter their current allocation despite improving economic conditions.

Industry super fund LUCRF Super has also been taking advantage of the sector’s performance. It was the first investor in April this year to invest in ME Bank’s new super cash management account, designed to maximise income for super funds with minimal risk.

The rise of emerging markets will also have an impact on fixed income assets, according to some industry players.

Legg Mason affiliate Western Asset Management launched a fixed income strategy in May to exploit opportunities within global credit markets.

The head of Australia fixed income at Western Asset Management, Anthony Kirkham, said in May that traditional methods of managing fixed income would change as emerging markets such as China exert increasing influence.

“Australia’s mainstream interest rate strategy will become strongly influenced by China in particular, and we are all going to have to become competent China analysts in the same way we are with developed markets,” he said.

Jeff Brunton, head of credit markets at AMP Capital, says sub-sectors of cash-enhanced products like fixed income are still in a sweet spot.

“Yields or spreads that fixed income provides, particularly in corporate bonds, are still quite wide, so the income that investors can generate out of what has been traditionally a pretty defensive asset class is quite impressive from historical levels,” he says.

The aftermath of the GFC caused spreads in the back half of 2008 to grow to seven-year wides.

While 2009 saw part of that widening being removed, we entered 2010 with spreads still pricing in a lot of negative news, close to their levels that they would typically be during recessions, where clearly the economic backdrop was much more supportive than that, Brunton says.

“It’s a great time to be investing when spreads are wide, because it provides us with such strong income,” he adds.

However, Standard & Poor's fixed income peer group review earlier this year found that bank deposit yields were more attractive when compared to the current returns offered by most cash and cash-enhanced products.

The European debt crisis

The European debt crisis and the resulting market volatility has ensured that cash will continue to play an important part in investors’ portfolios.

“Those sorts of issues are creating a lot of uncertainty in investors’ minds, and it means that particularly in Australia’s situation, where cash rates are high relative to other countries, it is increasing the short-term attractiveness of Australian cash,” says Schroders Asset Management’s head of fixed income and multi-asset, Simon Doyle.

Halmarick echoes Doyle’s comments.

Following recent events in Europe, “markets have been very volatile and risk appetite has been reduced, so that’s naturally lent itself to a greater demand for cash”, Halmarick says.

There was a steady inflow back into cash type products during May this year as investors have become more “gun shy”, he says.

“Probably one of the big changes is that investors are a bit quicker to jump back into cash,” Halmarick adds.

However, Burge believes that the European debt crisis, coupled with the Resource Super Profits Tax (RSPT), has negatively affected the performance of the cash sector.

“We’re all affected globally by the debt crisis in Europe, and the one distinguishing factor in recent weeks has been the announcement of the introduction of the Resource Super Profits Tax in Australia, and that’s clearly driven the Australian dollar down. Anyone investing in cash in Australia has suffered.”

Burge says investors should not get too stuck in the cash sector and miss out on growth opportunities.

“We have historically large holdings in cash funds and bank deposits at the moment here and in the US. [But] financial theory teaches us that for long-term investors you’re much better off in growth assets, otherwise we would all just stick to cash and treasury bonds. And the theory teaches us that there has to be risk premium over time for investors, otherwise we would never invest or take risks in growth assets.”

The cash sector can’t be expected to do well indefinitely, particularly if there is good value in share markets and good prospects for economic growth, Burge says.

“We have to assess that, and our assessment is that there are reasonable prospects for growth, and we think that right now it’s better off investing in Australian banks than investing in bank deposits.”

Defensive investors should consider a cash-weighted capital stable fund, which will act as a stabiliser on an overall investment, but with the advantage of some run with the share market if it starts to move up, Burge says.

But Lonsec head of ratings, income and alternative products, Michael Elsworth says that while the RSPT has not helped with confidence, it did not have much direct influence on the Australian dollar.

“The hedge funds, which treat the Australian dollar as a plaything, have had by far the major effect on [the currency rate]. They carry trade on, and when they decide to take it off you see these violent moves in the Australian dollar, which are certainly not uncommon,” he says.

One of the primary reasons for investing in cash, according to Elsworth, is rising interest rates. While they are on hold for the moment, they will continue to improve the attractiveness of the cash sector compared to other asset classes, Elsworth says.

UBS head of investment strategy George Boubouras says that while European sovereign debt is a big concern, investors should remember that the public sector assumed debt that had already been taken on by private companies before the financial crisis, and that prompted the idea that the principle of a common Europe and the European Union was being challenged.

“There are headwinds, however. There was a great recession and therefore the debt levels are quite high. But economies will recover and grow, as they’re doing, and [gross domestic product] globally has been revised higher every month for well over a year now, which is broadly conducive to export sectors and broadly conducive to any company that is geared to that global recovery out of Europe,” he says.

Investors simply have to be careful to pick the different regions where economic growth is being generated, Boubouras says.

While there are headwinds on the horizon in terms of European debt and global reregulation of the banking system, many of the headwinds have been priced in, Brunton says.

“It does feel like 2010 is going to be an environment where income stays strong — spreads will stay at high levels,” he says.

But investors still need to do their homework and stay on top of the issues, with top down research and a strong bottom-up team “doing the work on the 100-product issuers that should be in a diversified portfolio”, Brunton adds.

Product allocation

The question of what cash products investors should be using is a burning one.

According to Doyle, the GFC exposed the true illiquidity of cash derivatives, and investors are now shying away from cash-enhanced products.

“Investors [have] realised that there’s a difference between pure ‘cash’ from the perspective of liquidity, capital preservation and return certainty and ‘cash enhanced’ [products], which meant a lot more risk, and that ‘cash enhanced’ could actually deliver you outcomes a lot less than ‘cash’ and have problems in terms of liquidity,” he said.

Advisers may have also realised the problem. Perpetual expanded its credit team in May this year, citing a demand from advisers for “true-to-label” fixed income portfolios, appointing credit analyst Thomas Choi to focus on liquidity management within the portfolios.

Halmarick also says the GFC drove a push away from exotic structured products to more vanilla cash products.

“In the lead up to the GFC, [cash enhanced products were] increasing returns, but then the outcome of the GFC was a huge reduction in the value of those assets, and they were particularly illiquid, so the problem was that those mortgage-backed securities were worth significantly less than what they were recorded as — and due to their illiquidity, you couldn’t get out of them,” he says.

Products such as bank bills are back in favour as a result, he says.

UBS diversified its cash asset class early in 2008, introducing products designed to keep the asset class highly liquid and away from high yields, Boubouras says.

“We model portfolios and expect returns and sharp ratios across every asset class, but within cash it is liquidity and diversification that’s key,” he says.

The shake-up from the GFC has also meant that an industry focus on securing long-term funding is boosting investor opportunities for products such as term deposits.

"According to financial comparison website Ratecity, smaller financial institutions were offering returns up to 1.2 per cent higher than the major four banks for term deposits in June this year.

Elsworth believes that the massive amounts of cash in term deposits will create massive problems for cash-enhanced products like still-frozen mortgage funds and their ability to compete with the banks.

Those problems may even extend to the popularity of some fixed interest funds, he says.

“For years and years the banks didn’t really care about [term deposits], certainly at the retail level, and investors looked elsewhere to get returns. Now you don’t have to look very far to get a decent return that is government guaranteed. That has a massive effect on where cash is being directed in the short term,” he says.

Burge warns that international investors also need to factor in actual and prospective currency movements within the currency sector.

“It’s all very well to get your 1 per cent in the US dollar or the Japanese yen, but if those currencies are falling you’re not going to be doing well there either,” he says.

Asset allocation

How to use cash remains a challenge for some investors at a time when indicators of both a tough and favourable economic environment are emerging, Doyle says.

“One of the challenges that investors have is how do you use [cash] in a portfolio? Because cash should be liquid, [getting it] back at a rate close to the cash rate should always deliver a positive nominal return, so it is in a portfolio to provide you with short-term certainty and short-term liquidity.

“The negatives of holding too much cash is that cash rates can decline, and the returns on cash are only certain in the short term, and if you do go through a period of risk aversion, like ... the GFC, cash rates will decline close to zero,” he says.

Cash should be part of the defensive allocation within a portfolio under all circumstances because of liquidity, but under adverse market conditions investors should have investments like government bonds in that allocation as well, Doyle says.

Brunton says investors need to ensure a suitable investment horizon in allocating investments, but how many defensive assets they place in their portfolio depends on where they are in their lifecycle, and how much downside they’re willing to risk.

“When you look out for the next three to five years and you think about yields that you can generate from fixed income and think about what you [could have generated in the past 20 years], now is a really, really good time to be putting money into the fixed income markets.

“These are three to five-year assets, so for the next three to five years to generate effectively the consumer price index plus 5 per cent to 6 per cent [return] from the defensive part of your portfolio is quite attractive,” he says.

Brunton encourages investors to have a regional bias back into Australia and away from Europe and the US.

However, Boubouras expresses caution about the trend to abandon more complicated cash products.

“Diversifying across every asset class and then diversifying within every asset class is key because it worked through the GFC — when equities were minus 40 per cent, fixed income was up nearly 20 per cent and cash returned 6.9 per cent.”

UBS offers cash management trusts, bank bills, negotiable certificate deposits and commercial paper, Boubouras says.

“In different stages of your lifecycle you need more income certainty, with more income certainty as you age you need more bonds, so a capital stable fund [for example] would be a theme as you age.”

However, Boubouras also warns that investors should not jump too heavily into cash.

“If you put all your money into cash, and wait through your whole lifecycle, you’ll retire poor, and that’s a sad fact, so you need things like direct property and equities and corporate bonds,” he says.

The GFC and the positive performance of the cash sector has not changed Lonsec’s asset allocations in the long term, according to Elsworth, with the balance depending on a client’s risk profile.

Cash is a good part of a balanced portfolio in favourable markets, and current returns of 5 per cent or 6 per cent would offset unexpected periods of volatility in the market, Halmarick says.

Burge agrees and says that cash still has a place in a diversified portfolio, but he would only counsel placing everything into the sector to a defensive-minded elderly investor.

Doyle says the role of cash has not changed, but investors would do well to consider other defensive investments as well.

“The role of cash probably hasn’t really changed, the portfolios are still there for liquidity and short-term certainty. But I think that sort of volatility does highlight the need for other types of defensive investments in portfolios, like government bonds or duration-based investments that provide investors with an offset that appreciates in price.”