Cash conundrum: Investors and fund managers assess the cost of managing risk

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By Michael Armitage | 16 July 2015

Investors have done well for themselves in recent years. It’s no surprise, as trillions of dollars in government funding has flooded markets in an attempt to wash away the pain of the global financial crisis.

But just when investors were asking whether the Australian sharemarket has run too hard after three years of double-digit returns, the Greek debt crisis and China’s sharemarket downturn have ushered in another bout of volatility.

Risk management strategies are of particular importance to Australia’s $580 billion self-managed super fund (SMSF) sector.

As lifespans increase, they must simultaneously maintain a significant weighting to equities and other growth assets (or risk running out of money) while also managing against the risk of a market correction that may wipe out their retirement.

Boosting portfolio cash holdings is one of the most popular strategies – but it’s also one that should be considered carefully.

SMSFs already have a significant portfolio allocation to cash and term deposits: 27 per cent (or a record $157.4 billion), according to the Australian Taxation Office. However, it is an asset class which is no longer delivering strong yields as official interest rates have sunk to just 2 per cent.

Even equity fund managers are increasingly boosting their cash allocations as a way to manage risk in the current climate.

The BofA Merrill Lynch Fund Manager Survey (which surveys more than 200 managers holding more than $US600 billion) revealed in May that fund managers’ overweight cash positions jumped to a net 23 percent – the highest level since last December.

Meanwhile, the average small and large-cap Australian share fund increased its cash to 4.3 per cent from 2.6 per cent over the 12 months ended April, according to Morningstar. Several funds are holding almost 10 per cent of their portfolios in cash.

Even less constrained

Variable beta managers are even less constrained and have the ability to hold significantly higher levels of cash or short-sell stocks to manage capital risk. Historically, these fund managers have had an average net market exposure between 65-75 per cent leaving 25-35 per cent in effective cash.

The objective of the cash buildup is to provide risk management via a lower net exposure to the market.

However, these growing levels of excess cash holdings also act as a long-term drag for those investors expecting capital appreciation or a healthy dividend flow from their equity allocations. For many, a growing question is the level of management fee these managers are charging to sit in cash.

While such strategies can have a place in an investor’s arsenal they also rely on a high level of fund manager skill which can be difficult to assess. It can also be challenging to assess a portfolio’s underlying net market exposure as fund managers quickly change cash holdings in response to changing market conditions, especially when conducted on a discretionary basis. Further, while strategies that short-sell securities may seek additional alpha, investors should be conscious of various agency and custody risks inherent in these strategies.

However, there are also various ways this net exposure can be managed with varying levels of cost such as tail-risk hedging, target return/risk portfolios, and scientific beta approaches.

The use of futures

Strategies that manage market exposure through the use of futures don’t face the same higher transaction costs and potentially higher tax bills that equity managers selling down physical stock holdings and boosting cash holdings do. For strategies that are focused upon dividend income and franking, the use of futures can also be significantly more attractive as the underlying portfolio can be fully exposed to the yield and franking with the futures position not interfering with this process.

Market risk cannot be ignored. More than two-thirds of super fund executives say they expect another major market downturn to strike over the next decade, according to a recent AIST/BNP Paribas survey.

But risk aversion marks its own dangerous path and investors should explore the full range of alternative solutions.

The choices are there for savvy investors and their advisers to weigh up as they navigate a significantly more challenging investment environment.

This article was first published in Professional Planner.