Intuitively, all investors know the principles of buying low and selling high. Yet, we know investors tend to do the opposite of what works in investing because investment decisions are often driven by emotion. This is no different for most active managers as it is for a mum and dad in a suburban town.
Investors get excited when the market is rising and everyone else is buying. And of course, on the flip side, they panic and sell when the market is trending down. This behaviour leads to the poor outcomes identified by the ‘active manager underperformance’; growing evidence that active fund managers fail to outperform against the relevant index, as well as the ‘investor behaviour gap’; the difference between a fund’s reported return and the investor’s return.
Howard Marks, in The Most Important Thing: Uncommon Sense for the Thoughtful Investor, said:
“Every once in a while, an up-or-down-leg goes on for a long time and/or to a great extreme and people start to say ‘this time it’s different’. They cite the changes in geopolitics, institutions, technology or behavior that have rendered the ‘old rules’ obsolete. They make investment decisions that extrapolate the recent trend. And then it turns out that the old rules still apply and the cycle resumes. In the end, trees don’t grow to the sky, and few things go to zero.”
This is important to note in light of the active versus passive debate. While many investors expect active managers to utilise their full arsenal of weapons to derive outperformance, there is an agency effect at play.
What we find is that the average active fund manager has a cash balance that is negatively correlated with market performance. Said simply, managers tend to be fully invested at the peak of a market and raise cash levels during times of crisis. There are many plausible explanations why this might be the case, but the most logical reason is that managers raise liquidity in order to provide a funding source for potential outflows.
Is the Cash Drag an Issue?
This cash dilemma adds a layer of complexity to the active versus passive debate and raises a conundrum. We would intuitively want active managers to outperform, but it is difficult to outperform when cash is used for liquidity rather than as an allocation decision.
Let’s bring it to the present. The markets are at or near record highs, yet active managers have a lower cash balance than any other point in the past eight years. In fact, the average cash balance is now close to 2% versus a long-term average of closer to 2.7%. This could raise significant concern about the industry, especially if we do see a downturn in the near future.
While this may be a subtle indicator of excessive market optimism and warning sign against active outperformance, there are two questions to consider in this regard:
Is the low cash positioning likely to help or hinder performance in a forward-looking context?
Does it matter at a portfolio level if we manage our own cash exposures?
While we would argue that the first point is likely to be detrimental, it is worth reiterating that the fully invested mentality isn’t a bad thing as a multi-asset investor. It raises the further question of who we want to be making the capital allocation decision between equities and cash.
If we want the active managers to demonstrate a greater success rate against their respective benchmarks, allowing them to use cash as a tactical allocation tool may support this – it may also hinder it if they succumb to their own behavioural deficiencies and get it wrong. However, if we have the expertise to do this ourselves, we can remain comfortable with the ‘fully invested’ mentality and allocate our resources effectively. The key here is to understand the look-through capabilities at a total portfolio level.
Bringing our Focus Back to Behaviour
In times when investors are challenged by near-term market pessimism or euphoria, it is imperative that they acknowledge their underlying cash exposures and look beyond the noise. Experience has taught us to see the investing world through the lens of absolute and relative valuation; cautiously but positively awaiting opportunities to buy great quality assets at times when their price is below the intrinsic value. This principle exists independently of the underlying cash held by active managers.
