THE ROLE OF CASH IN PORTFOLIO MANAGEMENT
By Steven Mussa, Manager, Business Development – CDH

The transactionary role of cash (definition of cash; funds which can be accessed immediately, this can be in the form of cash itself or near cash investments) is a vital one. Neither a pension fund as a whole nor its individual investment portfolios can do without cash. The levels of cash that most pension funds hold are low when compared to the absolute levels of other asset classes. But without cash to oil them, the mechanisms of funds and the portfolios within them would seize up.

From a pure investment point of view, there is no reason for a pension fund to hold cash as a separate asset class, other than having it available for making investments immediately. Pension funds invest their assets over the long term. And in terms of matching liabilities, bonds provide a better match for the continuing long-term obligation of pension payments. Cash has no duration, neither does it have any formal link with inflation or earnings growth. So, from a liability point of view, it doesn’t fit as a strategic asset class.

But cash is needed, too, to pay benefits, normally as regular pension payments. Pension schemes in the Malawi, for example, offer their members the option of taking a proportion of their retirement benefit in the form of a cash lump sum or retirees may take all of their benefits as a cash sum at retirement. So cash must be available to meet these one-off or regular liabilities, whether it comes from the inflow of contributions or realisation of assets.

Within individual portfolios, any cash holdings represent a risk. If the managers are running a portfolio against a benchmark, as is usually the case, that benchmark assumes their portfolio is fully invested. Any cash that is held reduces the proportion of the portfolio that can be invested in the assets making up that benchmark. This increases the risk that performance will deviate from the target. In this way, holding cash produces what is known as ‘cash drag’ (Cash that a pension fund will carry to either meet redemption or seize perceived investment opportunities. Cash drag affects performance because the pension fund is not fully invested.

Even though cash should not be held as a strategic allocation within an equities portfolio, some see a danger that, across the industry, there could be a gradual drift in that direction. The problem arises where balanced portfolios are benchmarked to the average peer group. Because many balanced managers making up that peer group are likely to hold cash for tactical purposes, this could encourage benchmarked funds to hold cash as well, simply to stay tightly linked to the measure. In this way, cash could end up taking a place in the long-term strategic asset mix of pension funds, even though there is no valid reason for it.

In both pension fund total assets and within portfolios, cash has to be held as part of the investment activities. This is for two main reasons. First, for short-term liquidity. Cash flows in and out of a pension fund. Money comes in from employer and employee contributions, and flows out in the form of pension benefits and to meet the operational costs of the pension fund itself. Funds need some sort of central cash deposit to meet these ongoing costs. This might be managed separately as a cash fund or account.

Secondly, cash is used by investment managers within portfolios on a tactical basis. They need to have a certain amount of cash readily available in case a good investment opportunity comes along. Then they will be in a position to take advantage of it as quickly as possible, without the trouble of liquidating other running investments.

They may also use cash tactically as a defensive asset. Managers can temporarily switch some assets in an equities portfolio into cash if they foresee a dip in the market. But even this is a risky thing to do. The turning points of the equities market are notoriously difficult to ascertain. And, anyway, few managers these days have the freedom to take big positions in cash. Risk control systems are usually in place to prevent this.

During transitions, as well, where the overall asset mix of the fund is being changed, it is often necessary to liquidate some investments before others can be entered into. For managers managing bond portfolios, the risk of holding cash is not nearly as great as it is for equity managers. This is because the bond market is more stable. In any case, within bond portfolios, there is a legitimate role for cash within the investment mix. Money market instruments and notes – in other words, cash – can be held as shortterm bonds; they can be treated as duration moderators (basically they moderate a bond price sensitivity to changes in interest rates).

There are ways for a portfolio manager to minimise cash drag while at the same time maintaining the required level of liquidity. Derivatives (not common in Malawi) can be used to keep a high level of exposure to the equities market. By writing equity futures contracts on top of the cash the fund holds, the cash element effectively produces a return that is correlated with the equities market. For example, if the portfolio were to hold MK20 million in cash, the manager would write MK20 million on futures contracts to match the cash holding.

Although there is a cost involved in using derivative instruments, this solution is commonly used by index-tracking funds where the goal of following the index is paramount. In some cases, exchange-traded funds (ETF) can also be held instead of cash. These are baskets of securities – usually representing a market index – that are traded as a single share fund (the closest resemblance of this type of instrument on the Malawi Stock Exchange is National Investment Trust Limited: please note that NITL is not a perfect ETF). They are liquid investments that let an investor stay exposed in the equities market, with the advantage that they can be traded quickly and easily for cash or, in a transition situation, for investments that suit the new asset allocation.

While cash holdings within portfolios constitute a risk relative to the benchmark, and should be kept to a minimum, there are other important considerations. Any cash the fund has to have must produce as good a return as possible. Normally, the cash should not simply be put on deposit. The best option may be to buy into a pooled cash fund run by an external fund manager, such as an external money market fund. Typically, a cash fund would hold a range of different money market instruments. Larger pension funds may have their own liquidity funds.

It is also vital to assess and reduce counterparty risk. Since the collapse in 1995 of UK-based Barings Bank, there has been much more awareness that even large, old, institutions can fail. Although levels of cash in a well-managed portfolio are likely to be low in relative terms over periods of, say, a year, there may be times when large amounts of cash are held overnight or for a matter of days.

Institutional money market funds invest in cash and near-cash assets across different instruments, avoiding the problem of overexposure to one institution. If a fund finds itself in possession of a very large cash holding, the managers or the pension fund manager may collateralise it. This can be done by putting it into the repo market, where cash is exchanged for a government or corporate security. As long as the risks are carefully managed, the right level of cash can optimise the efficiency of an investment portfolio. But cash needs to be watched carefully to make sure it does not become a strategic allocation.

There are a lot of expert institutions which provide fund management services in Malawi and within the CDH group this role is under the jurisdiction of CDH Asset Management. This company is wholly owned by CDH Limited and some services which it provides are as follows;

-Pension Fund Management
-Gratuity Fund Management
-Special Purpose Fund Management
-Donor/Project Fund Management
-Endowment/Trust Fund Management
-High Net worth clients Fund Management; and
-Severance Fund Management.

Funds under management in CDH Asset Management Limited are invested in different asset classes Treasury bills, RBM Bills, Treasury Notes, Treasury bonds, equities, low risk corporate paper and property depending on the client mandate in addition to proposals which asset managers forward to clients after extensive research.

Headed by Mr Thoko Mkavea, a Chartered Accountant and seasoned expert in equities and other investments, CDH Asset Management Limited is located on the 1st Floor of Unit House along Victoria Avenue in Blantyre and there email address is
asset@cdh-malawi.com. The telephone and fax numbers are
01 821300 and 01830638. The views expressed in the article are those of the author personally and not necessarily those of CDH.

<< Back