Cashing in

Cash. Just saying the word conjures up the image of real money, not something that disappears into thin air or loses all its value when you aren’t looking.

It is this image of safety that has made cash so popular in an investment world where nothing seems terribly secure anymore.

From the millions parked in bank accounts under the protection of the Federal Government Deposit Guarantee to money market investment accounts, Australians have dived for the perceived safety of cash.

For advisers looking to the longer term, however, this rush to embrace cash investments raises questions about just how safe cash really is and whether clients are setting themselves up for yet another disappointment.

While some experts believe the move to cash is nothing more than a reaction to dramatic falls in the volatile asset classes, others believe it is time for a major rethink about the role of cash within an investment portfolio.

Far from merely providing liquidity and a comfortable stopover on the way to higher returning investment classes, they argue advisers need to give the inherent investment attributes of cash a much closer look.

Looking for safety

Whatever its use, everyone agrees there is a lot more interest in cash at the moment.

According to Macquarie Adviser Services senior product manager, cash, Peter Forrest, the level of interest in cash has increased dramatically.

“The past 12 months have seen a strong movement to cash as an asset, as investors seek security and certainty of return,” he said.

NAB Personal Banking executive general manager consumer product solutions, John Salamito, is another who has been observing the growing attention being paid to cash investments.

“We see an increasing interest in the product, especially due to the performance of the volatile asset classes,” he said.

Forrest believes the interest in cash is understandable, given the recent disappointment so many clients have experienced.

“With cash, investors are seeking a product where the rate of return is transparent and you can see what return you will receive,” he said.

“Cash is seen as an investment and an asset in its own right. It provides certainty of return and certainty of repayment.”

Pimco’s Australian head of retail investments, Peter Dorrian, agrees there has been growing attention paid to defensive assets such as fixed interest and cash.

“With many people in the equity market seeing returns decline significantly over the past 12 months, retail investors and their advisers’ interest in defensive assets … has increased substantially,” he said.

Even Lonsec is reflecting this, leaning towards the security of cash in its recommended tactical asset allocation. In the research firm’s June Quarter 2009 Investment Insight, its portfolio remained extremely overweight to the cash asset class.

Acknowledging interest rates had reduced significantly, the firm said cash was still important.

“While cash rates are moving down, investors need to be mindful that inflation is also retreating, so the real rate may still be reasonable,” the report noted.

“Investors should remain overweight cash until the global financial system is stable and credit is flowing again.”

Lonsec also noted the importance of capital protection in this environment, particularly while deflation remained a threat.

Problems ahead?

Despite the popularity of cash, not everyone is certain this is a good move by investors.

As Select Asset Management chief investment officer Dominic McCormick wrote in a recent issue of Money Management: “Investors who exited shares and property in the panic and de-leveraging of the last year may already be seeing some of these risks highlighted in the permanent losses that have been locked in and the dramatic underperformance of cash and bonds in the last three months or so.

“Certainly, the strong rally in all risky assets since early March seems to be causing (and partly reflecting) some rethinking on these defensive strategies.”

Roger McIntosh, Vanguard Investments Australia head of fixed interest, is another with concerns. He believes the current love affair with cash simply demonstrates “an element of risk averse sentiment” and is nothing more than a reaction to market volatility.

McIntosh feels investors often take a simplistic view, particularly after major market corrections.

“Investors usually tend to think in binary outcomes — shares or cash. People think that if they are not in equity then they are in cash,” he said.

“People have become so risk averse. They say cash won’t go down, but they need to ask why they are holding the asset in their portfolio.”

In McIntosh’s view, the main rationale for holding cash is as a source of readily available funds.

“Cash has a very basic purpose and that is to provide liquidity,” he said.

According to Stuart Fechner, Aviva’s distribution development manager investment products, investing into cash was an easy decision for many clients but moving back out could be harder.

“The huge investment flow into term deposits that we’ve seen over the past 12 months is only one side of a two-sided decision. Another decision needs to be made as to when to re-enter the market,” he said.

“A potential negative of investing in cash, especially for an extended period of time, is that investors may miss out on the rebound in equities when it occurs. You may be lucky to get it right, but it’s probably much easier to get it very wrong.”

Heading back to shares

Despite the concern about high cash allocations, most experts are fairly sanguine and believe the current situation is only a temporary phase until stability returns.

For Standard & Poor’s director of fund services, Jeff Mitchell, the present weightings to cash reflect the recent volatility.

“It is a change in the tactical rather than the strategic allocation.”

He believes a large tactical allocation to cash can be sensible, particularly given the current focus on capital preservation.

“A tactical allocation is a way to preserve capital and depending on what else is in the portfolio, it can be a very sensible approach.”

In its report, Lonsec was also quick to point out it expects investors to move out of cash once they become willing to take on more risk and start seeking higher yields.

“Cash will remain important to protect capital in the short term, but eventually Lonsec believes the quest for yield will be the major reason investors move back into the share market, once earnings and dividend visibility improves,” the report noted.

Forrest agreed investors are likely to leave the safety of cash once they perceive stability returning to the financial markets.

“As volatility reduces, investors and advisers will have more confidence to return to other assets,” he said.

Taking a risk

While investing in cash may make sense in the current environment as a way to protect capital, over the long term, being overweight to cash can create other problems, according to McIntosh.

“With cash you can be setting yourself up for failure, especially if you have a long time to retirement,” he said.

Salamito agreed heavily weighting a portfolio to cash is not without its own risks.

“Cash is perceived as a safe haven, but it depends on how you measure risk. If you are putting money away for something other than a cash purpose then you are not avoiding risk,” he said.

These often overlooked risks can include inflation, or the risk of not reaching your retirement income goals.

“A lot of people forget that liability matching is important and you need to match the goal to the vehicle you are using,” Salamito said.

“Cash is not safe if you are not matching your liability appropriately.”

According to McIntosh, there are also other risks.

“With fixed interest you get different duration characteristics, but this is less so with cash,” he said.

“With a much shorter duration product like cash, there is also a higher reinvestment risk.

“For fixed interest in a normal environment you get extra running yield, but the opposite is the case with cash.”

There is also entity risk to consider.

“With fixed interest you get exposure to different sectors such as sovereign risk and corporate risk, but with cash in an ING Direct-style product for example, you are often exposed to only one entity. At least with cash funds you are exposed to different entities and are diversified,” McIntosh said.

Although these risks are a concern, in the longer term most experts expect to see investors loosen their tight embrace of cash.

“We have definitely seen use of cash as a safe haven, but we also expect to see more of a reversion to the mean over time,” Salamito said.

“We believe in diversification and expect to see the money move back into more volatile asset classes.

“In the long term, advisers will always revert to cash as being an important but minor part of an asset allocation.”

Refocusing on cash

From Mitchell’s perspective, however, the current environment should encourage advisers to reappraise their use of cash in a client’s portfolio.

“People are definitely looking at cash as something other than liquidity in the portfolio. They are looking at cash through a different lens … Cash is a vehicle that has no credit risk, no duration risk and no liquidity risk,” he said.

Mitchell believes the importance of liquidity risk in many investments was not really appreciated until recent market events.

This view is part of a larger rethink about the use of cash in constructing good investment portfolios and the role played by each asset class.

Another urging a rethink about the role defensive assets like cash can play is Pimco’s Dorrian.

“The basic lesson is that diversification must be a pivotal part of how a portfolio is put together,” he said.

“The need for real diversification is the takeaway point from the last decade.”

McIntosh agrees advisers may need to reappraise their views about portfolio construction.

“You need to think about asset allocation first and depending on the particular circumstances of the client, then about how much should be put into each asset class,” he said.

This means considering what role each part of the portfolio plays and why it is included.

In Forrest’s view, the role of cash — particularly in terms of cash flow management within a portfolio — has not received sufficient attention in recent years.

“We are seeing advisers focus on cash flow management products and focus on where the cash is going,” he said.

“It allows advisers to know where every dollar is going. This leads to a greater focus on wealth accumulation and brings it front of mind. With good cash flow management tools, advisers can get through to clients the importance of this area.”

Reassessing the defence

A shift also seems to be coming in terms of the role defensive assets like cash can play in managing risk.

Dorrian believes ability of cash and fixed interest to combat growth asset volatility has been forgotten in recent years. “That reflects return seeking behaviour, not risk management behaviour.”

He believes over the past decade people largely forgot about risk and this has resulted in unbalanced portfolios too heavily weighted towards growth assets.

Mitchell agrees there needs to be a reassessment about risk within clients’ portfolios.

“It’s all about risk. People are refocusing on what risk is and what are defensive assets,” he said.

“In recent times we have seen defensive assets with a risk profile more like equity than bonds. The role of defensive assets should be there to stabilise portfolio returns.”

Advisers and clients are also becoming more careful about where they take on risks in their portfolio, Mitchell believes.

“Investors are asking, ‘Where do I want to take my risk along the asset spectrum?’, and it is not in defensive assets,” he said.

“People are more discerning about where they take risk.”