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Kevin Greenard: What is the ideal cash allocation?

There are numerous factors to consider when determining the appropriate amount to have set aside in cash. These factors include investment objectives, risk tolerance, time horizon, current market conditions, cash flow requirements, etc.
Kevin Greenard

There are numerous factors to consider when determining the appropriate amount to have set aside in cash. These factors include investment objectives, risk tolerance, time horizon, current market conditions, cash flow requirements, etc. When we have meetings with clients or prospects, one of the first questions we ask is what the cash flow requirements are for the next twelve to twenty-four months. This is a starting point on determining the appropriate amount of cash to have set-aside, and which account the cash should be in.

Portfolio Manager

Before becoming a Portfolio Manager, we would have to verbally phone each client to do each trade. When the markets were moving very quickly, it was nearly impossible to raise cash with every client when required. On the flip side, after the markets had declined, it was equally difficult to react quickly to reduce cash and get the funds invested quickly. After going through a couple of corrections in the markets, it was crystal clear that the only way to best service clients was to become a Portfolio Manager. As a Portfolio Manager, we can do trades on my clients’ behalf without having to obtain verbal consent for each trade so long as it fits within their Investment Policy Statement (see below). Becoming a Portfolio Manager was a decision that enabled us to be nimble and execute one block trade rather than hundreds of individual trades at different times.

Investment policy statement

When you work with a Portfolio Manager, the type of account you have is called “Managed”. This is the term used for a discretionary account. Scotia Wealth Management’s investment advisory arm refers to the program as Managed Portfolio Program (MPP). One of the requirements to open a managed account is to document their desired asset mix with the Portfolio Manager. As a Portfolio Manager, we have ability to do trades within the parameters established within the IPS. When discussing the asset mix within the IPS the conversation with the client primarily focuses on the desired long-term asset mix during normal times. We also discuss how we put ranges within the IPS to enable us to manage the asset mix during abnormal or uncertain times. Prior to taking on new clients, we always make sure that we are on the same page with respect to the parameters of the IPS and the ranges. Typically cash holdings can range from 0 to 40 per cent to enable us to react to market conditions during normal and abnormal periods.

Normal cash levels

Many of our clients do not have any cash flow requirements from their portfolio. These clients are either still working, have sufficient funds in the bank as reserves, or have other sources of income that are sufficient (i.e. registered pension plans, Old Age Security (OAS), Canada Pension Plan (CPP), rental income, etc.). For these clients, the normal cash level over the longer term is closer to zero. The asset mix in normal times would be allocated primarily to good quality equities for clients in a growth portfolio.

The remainder of our clients may require either periodic cash flow or lump sum cash transfers. The periodic cash flow is typically structured as a monthly transfer from their investment account to their bank account. Whatever the monthly cash flow need is, we will typically multiply this amount either by 12 months or 24 months to determine the cash wedge that we need to set aside for this purpose.

We also ask clients if they will require lump sum transfers in the next three years, or longer if they know. These transfers are typically done to purchase a new vehicle, home renovations, travel, etc. Once we know what those dollar amounts are, we typically will also earmark those anticipated funds, as a wedge, within cash equivalents.

Abnormal cash levels

We also recommend that investors interested in reducing the ups and downs in their investment accounts, during abnormal times, should hold a portion of their financial assets in cash.

It is prudent to increase or decrease your cash levels based on market conditions. Cash within an investment account can provide stability as well as the flexibility to purchase investments when opportunities arrive. The greater your cash balance, the less your portfolio should fluctuate with changes in the stock market. This includes market declines and upward rallies.

Capital preservation is one of the primary reasons to hold cash. Cash balances may also fulfill income requirements, as they generally earn a predictable level of interest income. The income is dependent on the type of investment, commonly referred to as cash equivalents. Cash equivalents are considered low risk and liquid (less than one year to maturity). The most common types of cash equivalents are: tiered investment savings accounts, money market mutual funds, treasury bills, and cashable guaranteed investment certificates (GICs).

Tiered investment savings account

The most common type of cash equivalent investment is referred to as a tiered investment savings account. A tiered investment savings account provides a competitive rate and is extremely liquid. These trade on the same platform that mutual funds trade on but are different in a few key areas. The following are the four key points to remember:

• Interest rates may be found on the respective companies’ websites and are subject to change (both up or down)

• High interest savings accounts are generally guaranteed through CDIC insurance up to $100,000 per qualifying account and issuer, provided the investment is denominated in Canadian dollars

• If a client deposits more than $100,000, we can invest in different tiered investment savings accounts to provide more CDIC insurance coverage

• High interest savings accounts generally trade at $1 a unit

• Interest is accrued daily

Money market mutual funds

Money-market mutual funds were created in the U.S. in the mid-1970s. Today, nearly all mutual fund companies around the world have a money market fund as part of their fund line-up. Typically, money-market funds are the most conservative type of mutual fund. New deposits (either lump sums or monthly pre-authorized contributions) and proceeds from stock sales may be put into a money market fund while you investigate new investment opportunities. Investors contemplating money market mutual funds should consider these five points:

• Returns fluctuate and may be negative

• Investment returns are not guaranteed and are not CDIC insured

• Money market funds trade at $10 per unit

• Investors with mutual fund holdings are typically able to switch within the fund family (from an equity or bond fund to a money market fund)

• Some money market funds restrict their investments to government or government-guaranteed while others include a large variety of riskier types of investments, including mortgages

Treasury Bills

Treasury Bills, also known as T-Bills, are purchased at a discount to their future maturity value. They are a popular way to hold cash equivalents for sophisticated retail investors but are used more frequently at the institutional level. Canadian money-market funds (mentioned above) often invest in a blend of federal and provincial government treasury bills, high quality commercial paper, bank certificates of deposit, and bankers’ acceptances. All of these short-term cash equivalents are considered to be relatively low-risk in nature. Mutual funds have large, constantly changing portfolios of these issues, and they are able to purchase T-Bills at wholesale rates. This differs from investors who only have small amounts to invest, require periodic income, or don’t want to lock in their cash for a specified period. The following are four points to remember about T-Bills:

• Generally guaranteed by the issuer (federal and provincial government)

• Funds are generally invested for a specific duration (i.e. 180 days)

• T-Bills are not automatically reinvested and involve you providing reinvestment instructions

• Yield-to-maturity is known at the time of purchase

• Are often used for individuals wishing to have foreign currency cash equivalents (i.e. US T-Bills)

Cashable GICs

Cashable GICs are considered cash because of their liquidity. Non-cashable GICs offer a higher interest rate than cashable GICs for similar terms. Often investors may have a combination of both cashable GICs and non-cashable. The following are three points to note:

• The rate on a cashable GIC is set for the term and is not subject to change like the high interest savings account

• Generally a cashable GIC must be held for at least 30 days to have the accrued interest paid if cashed

• Each GIC issuer is generally CDIC insured up to $100,000

As a Portfolio Manager, we have a fiduciary responsibility to always do what we believe is best for the client. When we decide to raise cash, maintain cash, or deploy cash, it is always through the lens of doing what is in the best interest of the client.

Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Senior Wealth Advisor with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at Call 250-389-2138.