There is a saying that ‘everything has a beginning, a middle and an end’. In the context of investing, this would mean that paying attention to the tails is as important as concentrating on the core. Download our Investment Guide to learn more about cash and private equity.
Excess cash: To hold or to invest?
Keeping a certain amount of cash on the side for a rainy day can be a reasonable strategy. However, holding excess cash can come at a rather large cost over time. Thus, is there a middle ground, and what should one consider?
Questions to consider
- Purpose: What is the purpose of cash in a portfolio?
- Income: Does the cash level support the desired cash flow generation (dividends and coupons) from the portfolio?
- Wealth generation: Does the cash allocation allow for long-term wealth creation? Is the portfolio’s overall composition likely to achieve an objective, such as making a major purchase or passing a certain amount on to the next generation?
- Timing: If the reason for holding cash is to wait for a better time to enter the market, is there a strategy in place?
Arguments for holding excess cash
- Transactional motive: An investor may have a short-term need for liquidity and therefore not want to commit the funds.
- Precautionary motive: An investor may have a lower risk tolerance and thus limit investments in financial markets. Reasons for such a stance could be the balancing out of other risks, such as business-related risks.
- Speculative motive: An investor may be very active in buying and selling portfolio positions. As a consequence the portfolio may hold substantial cash positions at times.
Arguments against holding excess cash
- Diversification: The first rule of investing is not to put all of one’s eggs in one basket but rather to be diversified. This rule also applies to cash, as it is like any other asset.
- No return on cash: Most cash in Europe has not been yielding a return for some time and the same is true for USD cash now.
- Inflation matters: Cash is like any other asset. If one does not take care of it, its value will decay over time. Cash loses its value because of the rise of the general price level as time goes by.
- Compounding matters: Albert Einstein is credited with saying: “compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn’t... pays it.” Investors with large cash positions pay a high price in terms of potential performance lost.
Private market investments: To be or not to be illiquid?
“To be or not to be illiquid? That is the question.” Further, stretching Shakespeare’s quote, the question becomes, “whether ’tis nobler in the portfolio to suffer the slings and arrows of public market volatility, or embrace low volatility private investments?”
Private equity is a term used to define any investment not publicly traded or listed on a stock exchange. More generally, the term private markets includes all non-public investments, including private debt investments. With such investments, investors are required to commit capital for an extended time-period in return for accessing return sources that are not available in the public markets.
Questions to consider regarding private market investments
It is not a black-and-white question of ‘to be or not to be illiquid’. As part of a diversified portfolio, one should perhaps consider both liquid and illiquid investments. Private market investments can complement traditional portfolios by providing exposure to new and growing companies, technological developments, and at times of distress, assets that are not available through public markets.They also have a longer investment horizon, which can make them a suitable investment for the next generation.
Illiquidity - it can also be a good thing
One way to gain private market exposure is via so-called ‘closed’ capital funds. A manager of such funds only requires delivery of the capital committed when they have investments to make. This stable capital set-up allows the manager to develop the investment without the fear of having to buy in times of euphoria (when prices are high) or having to sell due to investors wishing to redeem, often when markets are falling. In this way, ‘closed’ capital funds offer security to their investors because the managers do not become forced sellers at unreasonable prices.
There is much empirical evidence showing that good private-market investors can achieve competitive returns; this is in part due to the illiquid nature of their funds. The lack of liquidity can protect investors from their own emotions and a propensity to sell investments in times of stress. Thus, they participate in the upside of the investments when they recover – they will still be ‘in the trade’.
Not as illiquid as you may think
Non-listed ‘private market’ funds do exhibit a ‘natural’ liquidity through the purchase and sale of portfolio investments. This is because private market investors are temporary owners of assets, and they will always seek an exit at the right price and time. At this time, investors will receive their money back. Furthermore, there may be a private secondary-market offering investors an early exit route, if required.
To conclude, we encourage savvy investors not only to focus on the portfolio’s core, but also to pay attention to its tails.
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