Index investing usually beats active managers, but Larry Sarbit is one of the few who often comes out ahead.
"Cash, though, is to a business as oxygen is to an individual: never thought about when present, the only thing in mind when it is absent." – Warren Buffett, 2014 letter to Berkshire Hathaway shareholders
Since the economic debacle of 2007-08, markets have done nothing but ascend in the United States. The S&P 500's last down year was 2008. For the young and inexperienced investors, an appreciating market is the only one they know. But, as Mr. Buffett says, when events change, so too do investors' perception.
Against the backdrop of consistently rising markets, cash is viewed in a negative way. Interest rates are zero, so why would you hold an asset that delivers nothing?
Most actively managed mutual funds hold little cash because they have a mandate to be fully invested. The argument for this stance is twofold:
1. Portfolio managers (PMs) cannot time the market. If they are in cash, it exposes them to the risk of missing big stock price moves.
2. It is the job of the client's financial adviser to hold cash. The PM's job is to put the money to work, no matter the circumstances, no matter the valuations.
PMs in many large firms are mandated to be close to 100-per-cent invested at all times. Many PMs I know feel like they have a gun at their temples, with the phrase "Buy, you fool!" in their minds.
So is this in the best long-term interests of the clients?
Another source of this "fully invested" approach comes from the investment companies and PMs themselves. In the world of short-term "what have you done for me lately" investing, PMs feel they cannot afford to miss out in a bull market. Underperformance even for a quarter, much less a year or two, can result in redemptions for the fund companies and the PM losing his or her job. With so much on the line, holding non-performing cash is out of the question.
Then there is the rise of exchange-traded funds. The ETFs that track an index such as the S&P 500 have generally outperformed actively managed equity funds since 2008. These passive investing creatures are always fully invested and, as we all know, have very low monthly fees. The money pouring out of actively managed funds and into ETFs is on a parabolic trajectory. According to etfdailynews.com, the Canadian ETF industry alone has just crossed the $100-billion mark. These investment vehicles do not value stocks but rather buy stocks at any valuation without a thought. As a result, we find ourselves in a market where overvaluation of equities is becoming a challenge.
My history, as many who know me are aware, is one of holding cash. In 2002-03, my cash levels were so high (over 80 per cent) that Morningstar took the fund I was managing out of the "U.S. Equity" category and put me into the "Special" category – losing my 5-star rating in the process. I felt as though I was back in primary school, wrongfully accused of cheating and the teacher just ripped the gold star off my assignment. As a result of my extreme cash levels, I had the distinction of being written up in the Wall Street Journal in August, 2002. Fortunately, no letter home to my parents from the suspecting teacher followed.
During that time, it was less than fun speaking with advisers in Canada. I remember well going to adviser luncheons where advisers (some as tall as 6-feet-plus) would approach me (I'm 5-foot-4) and give me a lecture about putting their clients' money to work. Lucky for me, they were only armed with plastic forks and knives.
In meeting after meeting, I explained that stocks were expensive (the most expensive I had lived through) and I would remain disciplined, only buying stocks when bargains emerged. Of course, those bargains did emerge and I was happy to exchange cash for stock at the right valuations. After those returns came in, meeting with advisers was a far more enjoyable affair.
Markets have a history of cyclical behaviour. This has been a time in history when a fully invested, passive index tracking vehicle is king of the performance hill. With trillions of dollars in ETFs invested in North America, the industry has come a long way since the index mutual fund was first created 40 years ago.
Cash, in our opinion, is anything but trash. It gives us two great advantages. First and foremost, when investment opportunities arise, we have the cash to take advantage of them. Second, it gives investors some protection against stock-price declines while we wait for those better valuations to come.
Today, our cash weighting is around 50 per cent. Yes, we are earning nothing by holding onto cash today. And believe me, holding cash as an equity investor is no fun. We spend endless hours researching to find new investments with the same conclusions time and time again: Valuations are just too high to reward our investors with great rates of return. However, when prices eventually retreat, the returns we will get from buying great businesses at bargain prices will more than make up for the time we have earned a zero return on cash.
As the general economy remains mired in slow growth mode since the near collapse in 2008, having a wad of cash in your back pocket may not be such a crazy idea after all. As Mr. Buffett says, it can very quickly become the asset everyone wants and needs.
Larry Sarbit is the CEO and CIO at Winnipeg - based Sarbit Advisory Services. Sarbit is a sub-advisor on three funds for IA Clarington.