The Upside and Downside of Holding Cash

Earlier this week I discussed the unfortunate reality of holding cash – if you’re an investor or asset manager who holds cash you’re automatically less correlated to your benchmark.  This creates huge amounts of career risk for asset managers who are constantly compared to that benchmark.  And unfortunately, the people doing the comparing often aren’t benchmarking correctly or make these comparisons without properly accounting for the fact that “active” managers often hold cash.  This accounts for a big chunk of the managers who underperform their benchmarks – they have cash mandates or cash flow needs that require that they not be 100% fully invested all the time so they’re increasing the likelihood that their correlated benchmark is beating them.

Now, none of this is to excuse active managers for charging the high fees or creating the tax inefficiencies that often add to this underperformance.  But when we read about studies where active managers underperform it’s not necessarily because they’re bad at what they do (though, admittedly, many are) – they just aren’t doing things precisely like the index they’re often compared to.  In other words no one can realistically invest precisely like an index fund so it’s kind of silly to constantly compare yourself to an index that exists on paper and can’t be replicated perfectly in reality.

Of course, this can all be a good thing and a bad thing.  As I previously explained, most “active” managers (and really all investors) hold some cash at times because we all have cash flow needs.  Even the most “passive” investor has cash flow issues that require reinvestment or other issues that make them an imperfect “index”.   But cash can be a powerful tool in this regard.  For instance, while that cash might be creating some non-correlation to a correlated index (and increasing your underperformance risk) it’s also got the aspect of optionality that Warren Buffett talks about.  To an indexer this optionality can mean the ability to dollar cost average, rebalance, etc.  To a more active investor it can mean buying when others are fearful (as Buffett would do), making cyclical changes or being highly active (if that’s your thing).

So there’s an obvious upside and downside to cash just like any other asset.  But the important point is that cash is a necessary asset in our portfolio construction process and we all have to learn how to manage it.  Understanding its strengths and weaknesses is an important part of knowing how to do that.

Related:

• Why Your Cash Isn’t Trash – WSJ
• Putting the Underperformance of Active Managers in Perspective