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Fund spy: High cash balances hinder fund performance

Glenn Freeman  |  14 Dec 2019Text size  Decrease  Increase  |  
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A warm blanket, a life-jacket amid troubled seas, a safe place to hide while earning easy and reliable interest - cash has always been regarded as an essential component of any investment portfolio. And of course, it is - but its appeal as a driver of meaningful yield has taken a battering recently.

In Australia, we now have record low interest rates and historically low inflation – and at the same time, equity markets are soaring.

Reserve Bank of Australia governor Phillip Lowe says as much. In his latest RBA meeting minutes, he calls out low interest rates around the world, depressed bond yields and downward pressure on the Aussie dollar and an anaemic Australian economic growth rate of 1.7 per cent.

For "mum-and-dad" investors, it’s a struggle to know how much cash to hold, as Christine Benz discusses in a recent column. And it's also difficult for professional investors, says Morningstar associate director of manager research Michael Malseed.

"The ability for a long-only equity manager to make money from a cash call is difficult , because it brings in market-timing risk," Malseed says.

"When managers increase cash, they're often trying to protect against absolute losses – some active managers have a higher focus on absolute capital preservation instead of outperforming a benchmark."

Malseed notes that managers may have increased cash levels at the end of 2018, when more than half of ASX 200 stocks fell by more than 20 per cent from their 12-month highs. The ASX lost 6.8 per cent during 2018.

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But funds that sold out of equities in favour of cash missed at least part of the 26 per cent growth the ASX has delivered year-to-date in 2019.

This led me to question what the cash levels of Australian equity managers are currently doing. In a world where real interest rates – the amount you can earn on a dollar – are near zero, which fund managers have been hoarding cash on expectations stock markets will tumble?

For this comparison, I've identified Australian equity funds in Morningstar Australia's research stable that had the highest weighting to cash as of 30 November. This was restricted to long-only funds that focus on both large-cap and small-cap companies.

This criteria weeds out those with an absolute return focus, who hedge their stock calls and almost always have higher cash levels.

I then looked at the standard deviation of total investment returns over the past 12 months, three- and five-year performance relative to the benchmark. Two index trackers are used as benchmarks: the iShares S&P/ASX Small Ordinaries ETF for the small-cap funds, and Vanguard Australian Shares ETF for the large-cap managers.

Two main hypotheses driving this research are:

  1. Fund managers that took a bearish market view and boosted cash levels in the second-half of 2018 would have underperformed in 2019
  2. Those who stayed more heavily invested in stocks through 2019 are more likely to have beaten the benchmark.

The following Australian equity funds hold some of the highest levels of cash among those within Morningstar's research stable:

SG Hiscock ICE (1466)
Pengana Australian Equities Class A (18190)
OC Premium Small Companies (9852)
Hyperion Small Growth Companies (4242)
Perpetual Wholesale Ethical SRI (8649)
Hyperion Australian Growth Companies (3344)
Perpetual Wholesale Smaller Companies (4363)

How much cash in these Australian equity funds?

Funds cash holdings

Source: Morningstar Direct

Cash can drag on performance

Measured over the course of 2019, the SG Hiscock Australian equity fund's cash exposure of 17.5 per cent is the highest long-only fund in Morningstar's coverage universe. Its cash holding ranks second only to Pengana Australia Equities Class A on a three-year basis, too.

Morningstar manager research analyst Andrew Miles cites this high cash level as a drag on performance in 2017, though it helped in late 2018 when markets tumbled.

The fund's longer-term target is around 60 per cent in "growth ideas" such as value stocks along with a sizeable allocation to income stocks and around 10 per cent to earlier-stage companies.

Miles notes that the exposure to cash reached as high as 16 per cent in 2019. And this high exposure to cash hindered its performance during 2019, having returned 8.3 per cent over the year, and around 9 per cent over three and five years.

This performance is well below the index proxy we're using here, the iShares S&P/ASX Small Ordinaries ETF (ISO), which returned 16.24 per cent, 11.5 per cent and 12.5 per cent over one, three and five years, respectively.

Hyperion heads for safety

Two Hyperion funds feature in this line-up – Small Growth Companies and its large-cap offering Australian Growth Companies.

The small-cap fund's cash holding varied slightly through 2019. It held 11.3 per cent in cash at the end of November, 14.8 and 14.6 per cent in May and June – up from 10.2 per cent in January.

The exposure to cash of Hyperion's large-cap fund has typically varied by a few points either side, but the two fund's cash holdings average out over three years – 7.6 per cent for Small Growth Companies and 8.6 per cent for Australian Growth Companies.

Over 2019, the small-cap fund returned 11.5 per cent, versus 16.2 per cent for the benchmark.

The Hyperion large-cap fund's 2019 performance of 8.75 per cent lags the 11.4 per cent return from the Vanguard Australian Shares ETF.

Chief investment officer of Hyperion Asset Management, Mark Arnold, defends its higher cash positioning of recent years, and has an ominous warning for equities for the year ahead. "We're getting close to the end game now," he says.

Arnold believes record low interest rates and the looming end of what he describes as a "re-rating effect" - where equity market returns have been boosted by simultaneous declines of the cash rate and bond yields – is near.

"The returns from equity markets will be quite low, in the low single-digits, but you'll still have the volatility.

"And we think in that world, the penalty of holding cash reduces. That's the way we've been thinking about it, and that's why we've moved from 3 to 5 per cent in cash closer to 10 per cent.”

Going all in on equities

At the other end of the scale in terms of cash holdings is Allan Gray Australia Equity A (16128).

The Allan Gray portfolio management team seeks to be close to 100 per cent invested in the market at all times. Morningstar’s Miles says the fund has a persistent small- and mid-cap bias, and is fiercely contrarian in picking out-of-favour stocks.

Whereas many funds set cash ceilings at 20 per cent or higher, 10 per cent is the maximum this fund can hold at any given time.

Its cash holding at the end of September was just 0.5 per cent, and is 1.95 per cent when averaged over three years. But the real cash exposure is even lower, says Julian Morrison, Allan Gray's national key account manager and investment specialist.

"We of course always hold some cash in the fund so we have liquidity … but we equitise that cash position using futures," he says.

Allan Gray's cash holding is currently near its lowest point in its history, which dates back to 2005 in Australia and 1973 in the asset manager's homeland of South Africa.

The fund was slightly under the ASX Small Ordinaries in 2019, returning 13.24 per cent versus 16.2 per cent from the benchmark.

But Morningstar's Miles says comparison with this index is slightly unfair, given the fund holds a mix of large- , mid- and small-cap companies. For example, large-cap names Woodside Petroleum, Newcrest Mining, QBE Insurance and National Australia bank all feature among its top 10 holdings.

The Allan Gray fund beat the Vanguard Australian Shares index return in 2019 by almost 2 per cent, and outperformed by a similar margin over the three- and five-year average.

A possible red flag

In some cases, consistently high cash holdings by long-only active funds is a red flag for Morningstar research analysts. This is because it's extraordinarily hard for even professional investors to judge when best to sell out of stocks and buy cash, and vice versa.

This is one reason for the downgrade of The Montgomery Fund (19543) in August 2019. Alongside cash holdings that have averaged 22 per cent and have been as high as 28 per cent since 2013, the team wasn't able to demonstrate an ability to accurately time the market.

But none of this is to say that the higher cash-balance funds discussed earlier are bad. The SG Hiscock and Hyperion offerings are rated as Silver Medal funds by Morningstar analysts.
The point is that investors should be aware of the way individual managers' use cash before handing over their money.

Certain types of funds will be more appropriate for some investors than others depending on required levels of return, timeframes, risk appetite and the many other factors that underpin the importance of individual financial advice.

is senior editor for Morningstar Australia

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