In 1970, Warren Buffett opened a family safety deposit box to discover a letter from his grandfather and $1,000 cash. The letter, written to Buffett’s uncle on his 10th wedding anniversary, extolled the virtues of ready cash, explaining, “Over a period of a good many years I have known a great many people who at some time or another have suffered in various ways simply because they did not have ready cash. I have known people who have had to sacrifice some of their holdings in order to have money that was necessary at that time. Thus I feel that everyone should have a reserve.” He continued, “It is my wish that you place this envelope in your safety deposit box and keep it for the purpose that it was created for.”
As Ernest Buffett explains, managing strategic liquid reserves, or in layman’s terms, managing cash, is an important component of risk management. Often, when we discuss the importance of maintaining a cash reserve, it conjures images of cash stored in a coffee can, under a mattress or in Buffett’s case, in a safety deposit box. The idea of saving cash for a rainy day makes sense. However, while it makes sense conceptually, it is rarely effectively practiced for one or more of the following reasons:
- An emphasis on upside capture over downside protection, in other words, focusing on returns instead of risks
- The expectation that a “total return” approach to investing will always provide for distribution requirements
By “immunizing” near-term spending requirements in an appropriate way (which is a bit more involved than simply storing money in a Maxwell House can), Balentine empowers clients with the ability to pursue their long-term investment goals while still having assets and reserves on hand when needed.
As a starting point, it is critical to understand that managing the amount of cash reserved for distributions is separate and distinct from managing volatility across the broader portfolio. While some amount of liquidity will dampen overall volatility, cash reserves are not intended to protect against downside capture or tail risk to any great degree. Holding cash over and above strategic reserves for such defensive measures is a separate tactical decision.
Liquidity management can be broken down into two distinct categories – internal liquidity and external liquidity. An internal liquidity requirement refers to the reallocation of assets within the portfolio and will include capital calls (private capital) and deployment of cash across primary investment building blocks (safe assets and riskier assets). Conversely, external liquidity needs – spending and distribution requirements – include periodic distributions from the portfolio that draw down the overall principal balance. This includes tax payments, debt servicing, required distributions from IRAs, mandated foundation spending, obligations for endowments and so on.
In both instances (internal and external), the goal of the cash reserve is to eliminate the uncertainty around the source of the funds over the short to intermediate term, thereby “immunizing” distribution requirements. Although it is true that holding cash during a rising market dampens potential positive returns, this is merely an opportunity cost – not a realized loss. On the other hand, liquidation of assets during a falling market can exacerbate negative returns and create a realized investment loss that directly impacts the portfolio’s rate of return.
For example, if a client distributes 2.5% every six months from the portfolio – and does not maintain a cash reserve – the client would be required to sell assets in order to generate the cash needed for the distribution. If this sale were to take place during a severe market downturn, say a 10% decline, the portfolio would need to generate an extra 0.25% in investment return in order to compensate for the loss on the distributed capital. When you couple this hurdle with investors’ predisposition to loss avoidance, you create a powerful argument for the need to immunize distribution requirements from uncertainty – and thereby create a cash reserve portfolio.
The next step in the process is determining how much cash to hold in reserves. Balentine’s approach is to estimate the amount of money clients need for both internal and external purposes over a 12–month period. We also want to determine if that amount will remain constant or be adjusted for inflation over time. Once both the amount and rate are established, the next step is to formulate a policy dictating how much to allocate to liquid and/or safe investments.
Another key consideration is the extent to which the cash needed for distribution requirements can be generated organically within the portfolio through either dividends or income. A critical – and often overlooked – piece of the puzzle is the sustainability and diversification of the yield, as well as the frequency of the yield contribution. While the total annual yield may sufficiently cover the distribution requirements, the timing of the inflows may not align with the desired distribution schedule. Therefore, even if the client’s bond portfolio pays exactly the amount of an annual distribution, it does not always mean there is an equal trade-off. If the client withdraws a certain amount every month but only receives the interest to cover these costs every six months, an imbalance would exist for at least six months. Thus, it would not be practical to solely depend on the interest income for the spending needs.
Our policy at Balentine is to always maintain one year’s worth of required cash in reserve. The level of spending beyond one year is typically dictated by our global-macro risk outlook. Obviously, a higher-risk environment warrants a higher level of allocation to liquid and save investments to determine this.