Should Equity Fund Managers take Cash Calls? – November Newsletter
It’s a question that has been debated and discussed deeply in the financial community. Those who believe equity fund managers should go to Cash when the odds aren’t favorable suggest that the objective of a fund manager is to generate superior risk adjusted returns.
On the other hand, those who believe that the equity fund manager should not go to cash within the portfolio base their belief on the fact that the asset allocation is best left to the discretion of the client.
A not so recent thread on the subject
Cash calls in Asset Allocation can be taken in two ways. One would be based on Valuation while the second method is based on Trend. Both have their positives and negatives and it’s important to understand the merits and demerits of each before deciding on what suits one best. A combo works well as long as one is willing to stand apart from the crowd.
Compared to other methods of investing, a key expectation of Momentum Investing is going to cash when the market goes down. While from the theoretical angle of risk, this appears to be a great way to reduce the draw-downs, going to cash has draw-backs of its own including the fact that going to cash at the wrong time results in opportunity costs that are never calculated.
Even setting aside that, the issue with going to cash suggests that the strategy is more of a speculative strategy which inturn means that serious allocation becomes tough. The only time Cash as a position makes sense is when there aren’t enough stocks that pass through one’s filter. This happens rarely – last time it happened was in March / April of 2020.
Cash as a position has its utility when the odds are heavily stacked against the strategy.I don’t believe that we are at a stage where going to cash makes eminent sense. If the view turns out to be wrong in which case, we shall see a mid month shuffle.
Market Trends
Writing in March of this year, I used the idiom that Lightning doesn’t strike the same place twice to suggest that a big fall wasn’t on the horizon. Even though VIX in the US has done what it did way back in February 2020 – a breakaway gap of nearly 50% then and we have seen the same on Friday too, I think the future path isn’t looking similar.
In his book, New Methods for Profit in the Stock Market, Garfield Drew writes
The human mind is always inclined to go back to the past experience in the market and judge the future by that. Post Mortems may be held after each largely unforeseen collapse in order to determine what the warning signals were. Attention is then focused upon them for a time in order to avoid the next crisis , but when it comes, it is usually found afterward that the primary signs of danger had shifted to another field.
Since the original crash is still very fresh in Investors memory, the anticipation is that the current fall will be of a similar nature.
In early 2020, Markets were unprepared for the impact of an epidemic and one that seemed to shut down countries. The markets expected the worst well before the worst actually took place. When markets bottomed out, the number of new cases per day worldwide was just around 50,000 versus the peak we saw of nearly a million in early April of this year.
Broader market trends have been starting to show weakness for a while but not all weakness leads to crashes either. Number of Stocks (Universe being all listed NSE stocks) that are currently above their 200 day EMA stands at 60%, something we saw in September 2020. Markets saw a slight pull back before it bounced back with some ferocity.
Primary Trend: The primary trend in Nifty has been bullish as is easily evident from the lows of March 2020 seems to have now been broken. A break of the primary trend means that the market now will tend to trend either sideways – time correction or downwards – price correction.
In August 2013 Nifty began a strong rally upwards. The Primary Trend from February 2014 onwards was especially strong. This ended in March 2015 though the confirmation as such became possible only in June of the same year. The correction would last nearly a year with Nifty bottoming out in March 2016 before the next leg of the rally started.
I sense we are somewhere closer to March 2015 with a lot more sideways – slightly downwards action on the way.
“History Doesn’t Repeat Itself, but It Often Rhymes” – Mark Twain
There is no reason that the market should follow what it has done historically to the dot. What history provides us is a perspective from which we can draw conclusions and act on the same.
How did Momentum work during these times?
The backtest for the period shows that Momentum did not initially succumb to the weakness though it did bottom out with similar drawdown by the end. The reason for the divergence can be seen when we look at the performance of the Nifty Small Cap Index in the same period. While Nifty was trending down, this was trending flat. This enabled Momentum strategy to actually outperform both the Small Cap Index and the Large Cap Index for a while. From early 2016, the Small cap too took a severe pounding and took everyone down with it.
This time around, we don’t have that divergence. Large, Mid and Small Cap indices are behaving in a similar fashion and what this means is that there could be pain ahead regardless of the methodology one uses to be invested in the market.
So, how should one play this out?
This depends on what your time horizon is, your ability to digest a drawdown and the willingness to bear pain of a different nature if you are out and the market takes off.
While the Momentum Portfolio will continue to be fully invested as long as we have enough stocks that meet our criteria, the action can be taken from the asset allocation side.
The old adage – a penny saved is a penny earned doesn’t hold good in the markets. While saving a penny is always appreciated, it often results in an opportunity cost of two to three pennies. This is because while getting out is easy, getting back in full force when the market trend turns up once again but the overall newsflow is still very much negative is tough for most investors – new or experienced.
I wrote about some historical examples in this post – Mayhem in Markets. Will it End
Markets were due for a correction, this is something that everyone knew. The reason could have well been different and we would have seen the same action play out. The question though, what next is always difficult to predict especially in the short term.
I drive a bike and have been driving one for the last two decades and more. Roads being what they are, we do get into numerous potholes. The key to safe driving is not avoiding such potholes but avoiding the massive ones that can literally throw you off the vehicle.
In similar ways, I feel that the only time when we should get out of Equity and into the safety of Bonds / Cash is when we find ourselves on the cusp of a major drop. Small jerks are best accepted as the trade off for ability to garner returns that are way better than any other asset class.
When we look at market corrections, the calculation is between the peak and the trough. But neither are known other than in hindsight. Let’s assume that we cannot sell before the market is down 10% from the peak and buy back 10% above the trough. In essence we miss out on 20%. Gains accrue only if the fall is deeper and smoother without violent pullbacks that get smashed.
In the fall of 2000 (Dot Com bubble) for instance, Nifty rose 10%+ from the intermediate lows multiple times but failed. In hindsight, it’s easy to notice things that would have made one avoid getting caught in the bounce, but in reality, I remember seeing more money lost in these bounce back trades than in the first fall itself.
The key to successful investing lies in having an exposure that allows you to peacefully sleep at night even during the worst times but also has enough exposure to ensure that the goals are reached. Peaceful sleep can be had by stuffing the pillow with cash, but that doesn’t grow.
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