I’ve seen fund managers criticised for holding cash by investors who think a fund should always be fully invested. But at Montgomery we take a different approach. We believe holding cash, particularly when markets are frothy, gives us greater scope to buy stocks we like when markets eventually pull back.
The human bias toward focusing on return on capital, rather than return of capital, results in investors prioritising returns without due regard to the risks incurred in achieving those returns. The aversion to cash is predicated on the idea that any cash held limits the returns of a portfolio. There may be some truth to this but the characterisation of cash as an anchor on the fund’s performance might be disingenuous, given that it fails to capture the optionality cash provides.
Over the long run, keeping a sensible amount of “dry powder” gives a fund manager the ability to deploy cash in times of market sell-offs. In the absence of a cash holding when market turmoil approaches, a fund manager forgoes the opportunity to buy beaten down stocks and this actually detracts from long-term performance. The power to step in and act as the liquidity provider of last resort when everyone else is panicking provides an immense opportunity to buy stocks when others have not afforded themselves the same flexibility; arguably they have been hamstrung by institutional constraints – the relentless pressure to stay fully invested.
A key question to consider is who is in the best position to make the decision about how much cash to hold in a portfolio. Arguably the decision is best left to the fund manager. They are there at the coal face, searching tirelessly for stocks and are better able to gauge the extent to which value opportunities persist in the market, compared to others who are removed from the stock selection process. What then is the determination of a portfolio’s cash weighting based on?
The cash weighting of a portfolio is not determined by concluding that markets appear expensive and that keeping a specified percentage of cash is thus appropriate – to do so would be akin to a broad macro call on the direction of stock markets and that we are prescient enough to time the inflection point. The truth is we do not have such an ability. Instead, we view our weighting of cash in the portfolio as an output, informed by the opportunity set of investments prevailing at any one time.
When individual stocks we are interested in become cheap, we seek to deploy relatively more cash. Conversely, when these stocks become expensive there are less opportunities for us to put capital to work and the cash position builds accordingly. To subscribe to the mantra of always being fully-invested is in our view imprudent, particularly in times when equity markets are running hot. Holding your nose and purchasing securities at prices you would otherwise shun, in order to remain fully invested, runs contrary to our overarching desire to preserve and grow the capital of our investors.