July 2006
Cash (a.k.a. money market funds) gets little respect as an investment option or even as a risk management tool in the financial world despite the fact that it has earned a better return than the S&P 500 Index over the last six years. In fact, cash became "trash" in the early part of this decade as the Federal Reserve lowered the short-term federal funds rate to 1% to ward off the threat of deflation. Cash has played an integral part of risk management in our investment strategy. With money market rates now surpassing 5% we think more investors will not only come to appreciate these virtues but also see cash as a reasonable investment alternative in the months ahead. Cash ain't trash anymore!
When I became an investment manager in 1982 most people had most of their savings in money market funds. Cash was king! Investors had suffered for more than ten years in a bear market for stocks and bonds. It was understandable that rational individuals would be seeking an investment option that was both safe and paying a rate of return in the mid-to-high teens.
As the bull market in stocks and bonds got started and gained momentum in the 1980's managers like me had the challenge of persuading clients to leave the safety of their money market funds (whose rates were falling) and venture back into the "risky" but cheap stock and bond markets. While events like the 1987 stock market crash would temporarily frightened some people back into money market funds, most people could not resist the opportunity to earn the big returns that the stock market was providing in the 80's and 90's. They became macho risk takers. Cash was for sissies.
Cash was a drag on investment returns in the prior two decades. And since stocks only seemed to go up, what was the point in holding any cash? Clients insisted on keeping cash balances at a minimum in their portfolios. A few of them would even yank it out if it was not invested quickly enough.
Despite the drubbing that most investment portfolios suffered in 2002 after the bursting of the tech stock bubble in 2000, cash has still not regained the respect it had as a wealth preserver in the late 1970's and early 1980's. People are still uncomfortable with cash sitting in their portfolios.
Part of the reason for this is that the stock market has recovered much of what it lost, with the exception of certain technology and large-cap growth stocks. Also, money market rates fell so low that stuffing the cash in a mattress almost became a viable alternative. That has changed.
Over the last two years the Federal Reserve has increased short-term interest rates 17 times to slow the economy down and to keep inflation under control. Money market fund rates have increased from less than 1% in 2004 to almost 5% today. With new Fed Chairman Ben Bernanke having to prove his stripes as an inflation fighter, many economists believe we will see higher rates later in the year even if there is a pause in the rate hikes in August. We agree.
As money market funds and other short-term securities offer rates over 5%, we think investors will become much less anxious about having larger cash balances in their portfolios. It wouldn't be all that surprising for us to see some investors looking back five years from now to see that cash made them as much or even more than many broad stock market index funds did.
Should the Fed continue to raise short-term rates to the 6% level, history has shown that the stock market would be in for a very rocky ride. Over the past 40 years, the stock market has declined 6 out of 8 times that the federal funds rate rose to 6% or higher because of the detrimental effect on the economy. The last time was in March of 2000.
The recent rise in the volatility of the stock market should also lead investors to seek out investment strategies to soften the ride and cash provides an effective cushion. The fast and furious declines in the emerging market and small cap stocks that occurred in May and June left some macho investors yearning for the safety of cash in the face of a possible beginning of a new bear market decline. It is at times like these that the attributes of cash as a risk management tool are better appreciated.
We have and will always incorporate cash into our investment strategies. Our firm was founded on the principle that it is our mission not to lose our clients' money and to make money when we think the probabilities for better than cash returns are high enough to warrant the risk of exposing our clients' money to riskier assets. It was a difficult decision to hold a lot of cash when money market rates were below the inflation rate. With rates now about 2 percentage points above inflation, it is much easier.
Many people do not realize that cash also needs to be managed to maximize returns, especially when cash levels are above normal. It is not as simple as just putting it into any money market fund. Most typical brokerage firms offer a variety of funds with different rates both taxable and tax-free. Making the right choice actually can add up over time.
There are also other alternatives to money market funds that can be used to maximize returns for the cash balances. Besides the very popular 3-month or 6-month U.S. Treasury bills, there are lesser known short-term securities that can add a significant boost to the portfolio's cash returns.
For example, there are 7-day and 28-day auction rate notes that are taxable or tax-free. By buying these directly, it slices out the fees charged by money market fund operators. Granted, investors aren't as diversified as owning a money market fund, but holding these very liquid, very high quality and very short-term investments can add a quarter to a half of a percentage point to cash returns.
Cash is not a viable long-term investment solution for people needing to build wealth or even protect it against inflation. That is what stocks, bonds, real estate and commodities are for. However, there are times in the financial markets, like today, when cash can offer a great place to protect our clients' money and earn a competitive return as we look for better investment opportunities to come. Having done this job for long enough, it is safe to say that they always do!
John W. Gudritz, CFA
john@frontstreet.com