Holding cash in your portfolio can provide comfort in uncertain times. During downward markets a term often heard is “Cash is King.” The purpose of this article is to talk about the importance of cash within the asset allocation. It can minimize the effect that volatility has on an investor’s portfolio by ensuring they are not forced to sell an equity at the wrong point in an equity market cycle. The additional funds allocated to other asset classes outside of the cash wedge can then be used to invest and grow.
Normal cash levels
At the beginning of every meeting we have with our clients, we ask what their cash flow needs are. Cash flow needs are adjusted on an ongoing basis depending on what each individual client requires. For example, with inflation costs rising some clients are finding they need a bit more each month from their investments. Or a client may be retiring next month and wishes to start taking a monthly amount from their investments. On the flip side, others are finding they are not travelling as much now and can reduce the amount they take from their investments.
Over half of our clients do not require cash flow from their investments. 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 close to zero. Their asset mix in normal times would be allocated primarily to fixed income and equities. In these abnormal times, we are decreasing or eliminating fixed income for our clients and implementing a cash wedge strategy for any cash flow needs they have.
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 any lump sum transfers in the next two to 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.
Placement of cash
Earmarking cash for upcoming cash flow needs is one component. A second component is to ensure that the cash is available in the correct account.
Holding cash in the non-registered account enables flexibility. There are no tax consequences to withdraw cash from a non-registered account like there would be from a Registered Retirement Savings Plan (RRSP) or Registered Retirement Income Fund (RRIF). We also rarely hold cash in a Tax-Free Savings Account (TFSA) or a RRSP as both of those accounts are great vehicles for long-term, tax-sheltered investment. Instead, the cash is held in a non-registered investment account from which we can send monthly systematic withdrawals and lump-sum transfers, as well as make periodic payments on behalf of our clients such as quarterly tax installments or annual insurance premiums.
For our clients who have a Registered Retirement Income Fund (RRIF), if we know what their RRIF payments will be, and if they are taking those payments in cash, then we also have those funds set aside to fund their annual RRIF payments.
Cash wedge strategy illustrated
With the cash wedge strategy, we set aside one to two years’ worth of cash flow needs from the investment portfolio into a cash equivalent that has no exposure to market volatility. While it may earn a small amount of interest, it will not go down in value. Depending on the client’s individual circumstances, the remainder of the portfolio can then be invested in good-quality blue-chip equities that pay a dividend and have share price appreciation, both of which will help the investment grow over time and help the investor keep pace with inflation.
To illustrate, we will look at Mrs. Smith. She has $2,000,000 invested with us, and requires $5,000 per month from her investments. She is also planning a trip later this year which she will require $10,000 for, and purchasing a new car the following year for $40,000. To calculate Mrs. Smith’s wedge, we add up all her required cash flow for the next 24 months. Her monthly income requirements total $120,000 ($5,000 x 24) and her periodic income requirements total $50,000 ($10,000 + $40,000). Mrs. Smith’s total wedge in her portfolio equals $170,000 ($120,000 + $50,000) and is held in her non-registered investment account. The remainder of her funds, or $1,830,000 ($2,000,000 - $170,000), are invested in high-quality blue-chip equities that pay a dividend or have growth potential.
Using this cash flow strategy, Mrs. Smith does not hold any fixed income in her portfolio in the current fixed income environment. While this may seem like a large amount to hold in cash, it only represents 8.5 per cent of the overall portfolio ($170,000 / $2,000,000), and provides comfort to Mrs. Smith knowing that she will not be forced to sell an equity at a low point in the market cycle to meet her short- and medium-term cash flow needs.
Strategic versus tactical asset allocation
Investors have two types of asset allocations. The first is their strategic asset allocation, which is their target allocation as set out in their Investment Policy Statement (IPS). The second is a tactical asset allocation which gives room to temporarily overweight or underweight an asset class within a pre-determined range. This is to take advantage of current market conditions, such as increasing the amount of cash within the portfolio. These pre-determined ranges are agreed upon in advance by the client to ensure we are always executing their plan.
Depending on the situation, we recommend that investors interested in reducing the ups and downs in their investment accounts, during abnormal times hold a portion of their financial assets in cash. The decision to do so is considered a tactical asset allocation decision.
Increasing or decreasing the portion of your portfolio held in cash based on economic indicators and market conditions is prudent. Cash can be viewed as a safe harbour, similar to a bank or savings account, and — within an investment account — provides the flexibility to purchase investments when good opportunities arise.
The greater your cash balance, the less your portfolio should fluctuate with changes in the stock market, including declines and upward rallies. It’s important to find the right balance of cash so that you are comfortable with the amount of risk your portfolio is exposed to in the markets. Investors with cash when markets decline are able to take advantage of lower stock prices. The downside to this is if the market begins to correct before that cash is invested, you miss out on some of this increase.
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), which we will discuss in more detail below.
Creating an Investment Policy Statement with your Portfolio Manager
As a Portfolio Manager, we can process trades on our clients’ behalf without having to obtain verbal consent for each trade assuming the change fits within the parameters of their Investment Policy Statement (IPS). Becoming a Portfolio Manager was a decision that enabled our team to be nimble and execute block trades at the same time rather individual trades at different times.
When you work with a Portfolio Manager, the type of account you have is a discretionary account (also known as a managed account). At Scotia Wealth Management, we offer our Managed Portfolio Program (MPP).
One of the requirements to open a managed account is to document the desired asset mix with your Portfolio Manager within an Investment Policy Statement. To make sure your portfolio is aligned with your financial plan, we process trades within the parameters established for your individual circumstances.
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 — this is the strategic asset allocation referred to above. We also discuss how we put asset allocation ranges within the IPS to enable us to manage the asset mix during abnormal or uncertain times — this is the tactical asset allocation referred to above.
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. One of the most important components of the Investment Policy Statement is that it details the income requirements from the portfolio for the next two years.
Managed Portfolio Program agreement
One of the documents that clients sign when opening a managed account is a form called an “Investment Management Agreement Managed Portfolio Program”. This agreement outlines many things, including our fees. It is important to highlight that our standard fee for clients does not apply to cash held within a tiered investment savings account — these investments are excluded from the fee calculation.
As a Portfolio Manager, we have a fiduciary responsibility to always do what we believe is best for the client. Often, we raise cash for our clients even though this means our compensation decreases. Holding an overweight position in cash is generally not meant to be a permanent decision, but rather a prudent strategic shorter-term adjustment based on conditions as we see them.
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 with settlement taking place one day following the trade date. These trade on the same platform that mutual funds trade on but are different in a few key areas. The following are the five key points to remember:
• interest rates may be found on the respective issuers’ websites and are subject to change (both up or down);
• tiered interest savings account investments 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; and
• interest is accrued even if the investment is held for only a day.
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); and
• 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, 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 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. Many mutual funds have large, constantly changing portfolios of these issues, and they can 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 five points to remember about T-Bills:
• generally guaranteed by the issuer (federal or 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; and
• T-Bills are often used for individuals wishing to have foreign currency cash equivalents (i.e. U.S. T-Bills).
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 GICs. 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 tiered interest savings account;
• generally, a cashable GIC must be held for at least 30 days to have the accrued interest paid if cashed; and
• each GIC issuer is typically CDIC insured up to $100,000.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250.389.2138, email email@example.com, or visit greenardgroup.com.