Asset allocation refers to the percentage an investor has in cash, fixed income, and equities. This article will focus solely on the cash component.
Investors interested in reducing risk, and volatility in their investment accounts should hold a portion of their investment portfolio in cash.
Determining how much to have in cash is dependent on each person’s situation and the discussions you have with your portfolio manager.
Investment Policy Statement (IPS)
In several of our past articles we have written about the importance of communicating your cash flow needs to your portfolio manager. We prepare an Investment Policy Statement (IPS) for every client that outlines the minimum and maximum levels of cash.
For the majority of clients, the minimum is set to zero, and the maximum is set to 40 per cent. Both the minimum and maximum amounts of cash can also be customized. The purpose of the IPS is to provide your portfolio manager guidance on how you would like your money managed, including the appropriate level of cash.
Cash flow needs
Within the IPS we document our client’s cash flow needs for the next two years.
For example, if the client requires a set monthly amount from their portfolio, we set up what is called a Systematic Withdrawal Plan (also referred to as a SWIP). Although the SWIP is an automated process, the portfolio manager has to make sure cash is in the investment account at the end of every month to facilitate the transfer. If the client has prepared a cash flow budget, then providing this is a good starting point in the discussion to determine the correct SWIP.
Let’s illustrate this with a client who would like $3,000 per month transferred from her non-registered investment account to her bank account. At a minimum, we would want to have $36,000 set aside for these monthly payments. If clients wish to be even more conservative, we will set aside even more cash.
Liquidity
Prior to doing any investing we ask clients whether they need any funds within the next two years, aside from the cash flow mapped out for the SWIP.
For example, if you are planning to purchase a new car or recreational vehicle then you should let your portfolio manager know, especially if you have not already set aside these funds in the bank account.
Are you planning to change homes, renovate an existing house, or have any planned repairs? Perhaps you are wanting to plan a special holiday or occasion. Anything that would result in you possibly asking your portfolio manager for money in the future should be considered.
Other cash payments
In addition to the cash flow SWIP and the liquid cash required, some cash is often required for other reasons. We have clients who are supporting children or parents and have requested that we help them with periodic transfers to them. Some are sending money to family in different countries and we assist them with currency conversions and wire transfers.
We also make quarterly instalment payments to ÎÚÑ»´«Ã½ Revenue Agency (CRA) for most of our clients who are required to do so. There are times, when significant assets are sold, that an accountant will advise that cash is set aside to fund the tax liability.
Similar to instalment payments, we can make our clients’ annual income tax payments if directed. Many of our clients instruct us to pay the annual insurance premiums for life insurance, disability, and other types of insurance. In the majority of cases, paying your insurance with a lump sum annual payment will cost less than arranging to pay it monthly.
Establishing a comfortable wedge
The cash flow components are the monthly SWIP, liquidity needs, and other requested cash payments. Some may be one-time payments, and others may be ongoing. The money that we set aside for these cash flows is called a “wedge.” Prior to doing any investing, it is important to establish a wedge that you are comfortable with.
The length of the wedge is another factor. In the majority of situations our clients will have cash set within a wedge to cover the next 12 months. Our conservative clients will want to have 24 months.
Tactical cash component decisions
Increasing or decreasing this portion based on economic indicators and market conditions is prudent. Cash within an investment account can be viewed as a safe harbour, similar to a bank or savings account. Investors who have cash will have the flexibility to purchase investments when good opportunities arise.
Cash impacts risk and reward decisions
The greater your cash balance, the less your portfolio should fluctuate with changes in the stock market, including declines and upward rallies.
Investors with cash when markets decline have the ability to take advantage of lower stock prices. Investors with cash when markets increase are not participating in the upside. Finding the right percentage of cash is important so that you are comfortable with the level of risk you are taking.
Cash is capital preservation
Capital preservation is one of the primary reasons to hold cash. Many people may have mentioned that with interest rates so low, investors are not achieving a real rate of return after inflation.
Cash balances may also fulfil income requirements, as they generally earn a predictable level of interest income, albeit a very low level of 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: money market mutual funds, treasury bills, high-interest savings accounts, and cashable guaranteed investment certificates (GICs).
Money market
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 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
High interest
Another type of cash equivalent investment is available which we will refer to as high interest savings accounts. High interest savings accounts have competitive rates and are very 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
• high interest savings accounts generally trade at $1 a unit
• interest is accrued even if the investment is held for only a day.
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
• cashable GICs must generally 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
There are some very good risk management reasons to split significant cash equivalent balances into different types and issuers. One reason may be to take full advantage of CDIC insured investments (see www.cdic.ca for complete details).
Regardless of the type, you should ensure you are receiving the maximum return on your cash balances while maintaining liquidity for opportunities.
Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director, wealth management, with the Greenard Group at Scotia Wealth Management in Victoria. His column appears every week on timescolonist.com. Call 250-389-2138.
