Cash Allocation Discussion
I've been pondering the cash allocation predicament recently and wanted to get some outside opinions. I realize there is no simple formula, and this frankly isn't something that needs to be considered in the average investor's professional life-- LPs are paying you for a specific investment product, not to have their investment sit in cash, so you'll likely be more or less fully invested most of the time.
But let's say that you are an opportunistic family office that needs to set a target allocation. Goal is to beat the market by a couple hundred basis points. None of this money is to be used for anything except investment, so you don't care that much about illiquidity. What's the right amount of cash? A money market spitting out a risk-free (on a nominal principal level) 5% is not bad. Even reaching for a 7% yield from a corporate bond likely introduces more than 200bps of incremental risk.
If you want to beat the market, cash will be a drag most of the time... until it isn't. Of course, in hindsight, the right cash allocation for most of the last 10 years has been close to 0% (even the few times that it would have behooved an investor to have a lot of cash-- ie covid crash-- the real rates were near or below 0%, which is better than a loss on a risk-asset drawdown, but not helpful yield-wise, so the question was not as prevalent back then).
What's the best way to think about this? It likely needs to be a dynamic process, and the variables are too numerous to count. I realize this way oversimplifies basically everything, but I thought a good starting point would be to name some target allocation (maybe hsd to lower double digits), then adjust based on market valuation vs history (again, extreme oversimplification) or the vix (something like vix over 30 = decrease cash).
Ah, the age-old question of cash allocation, especially within the context of a family office with an opportunistic approach. Based on the most helpful WSO content and threads, let's dive into this intriguing topic. The goal, as you've mentioned, is to beat the market by a couple of hundred basis points, which is no small feat. Here are some insights and strategies that might help guide your decision-making process:
Dynamic Cash Allocation Strategy: As you've rightly pointed out, a static cash allocation strategy might not be the best approach, especially in a market that's as volatile and unpredictable as the one we've been experiencing. A dynamic strategy that adjusts based on market conditions, valuation metrics, and volatility indicators (like the VIX) could offer a more nuanced way to manage cash allocation.
Market Valuation and Historical Comparison: Using market valuation compared to historical averages can be a useful tool in deciding when to increase or decrease cash holdings. When markets are significantly overvalued based on historical metrics (e.g., P/E ratios, P/B ratios), it might be prudent to hold a higher percentage of cash in anticipation of a market correction.
Volatility as an Indicator: The VIX, or the volatility index, can serve as a temperature check on market sentiment and fear. A higher VIX often indicates higher market stress, which might suggest it's a good time to hold more cash. Your idea of using a VIX over 30 as a signal to increase cash holdings could be a practical rule of thumb.
Opportunistic Investments and Illiquidity Concerns: Given that the family office doesn't have significant concerns about illiquidity, this opens up the possibility of holding a portion of the portfolio in more illiquid investments that can potentially offer higher returns. This could include private equity, real estate, or direct investments in startups. The cash allocation, in this case, serves as a buffer and enables the family office to take advantage of these opportunities as they arise.
Yield-Seeking in a Low-Interest Environment: While cash might traditionally be seen as a drag on performance, in a low or negative real interest rate environment, finding yield without taking on excessive risk becomes a challenge. Exploring short-duration corporate bonds, high-quality municipal bonds, or even certain types of asset-backed securities might offer a middle ground—providing a yield pickup over traditional money market funds without significantly increasing risk.
Scenario Planning and Stress Testing: Regularly conducting scenario analyses and stress testing the portfolio can help identify how different cash allocation levels might impact the portfolio under various market conditions. This can inform more strategic decisions about cash allocation.
Feedback Loop and Continuous Monitoring: Finally, having a robust system in place for monitoring market conditions, portfolio performance, and the effectiveness of the cash allocation strategy is crucial. This should include a feedback loop that allows for adjustments as new information becomes available or as market conditions change.
Remember, while these strategies and considerations can provide a framework, the optimal cash allocation is highly dependent on the specific goals, risk tolerance, and investment horizon of the family office. Engaging in continuous learning, staying informed about market developments, and being flexible in your approach will be key to navigating the complexities of cash allocation.
Sources: Best way to learn PE relevant finance: I've done modeling practice, but it's going over my head, https://www.wallstreetoasis.com/forum/private-equity/thinking-like-an-investor-the-key-financial-metrics?customgpt=1, How to think about Debt for Acquisitions, Is it better to have good ideas or smart allocation, How would you invest $5m cash?
Bumping as I'd love to hear how others would think through this.
I have ~$6mm invested currently and am a relatively aggressive person. This may not be how a family office would approach it because they probably are doing more illiquid things. But how I think about it is as follows.
Core allocation is 70% broad based index ETFs that I never intend to sell.
0-20% in concentrated basket of individual stocks I like (0% if I hate everything, 20% if lots of opportunities)
And 10% in cash/fixed income if that full 20% is allocated to individual stocks, more if not. Fixed income currently is just rolling short term treasuries. I don’t think you pick up enough yield owning credit for the incremental risk right now.
How I got to 10% cash/fixed income is I generally want to have $500k in liquid stuff that isn’t stocks as a personal preference. It also gives me flexibility if things get really cheap to deploy aggressively. I would be open to having 100% in stocks if I felt there were lots of opportunities. But in the meantime I like the comfort of knowing I have $500k cash (10%ish) which ensures I would never need to dip into my stock holdings for anything. Tax deferred compounding in ETFs with a few special situations layered on top of it is how I like to do it. With my day job I have the benefit of incrementally legging into the market over time as well with savings.
Thanks for your response-- very similar situation and strategy as me, although I've layered in a little bit of private exposure. I agree that credit is probably not worth the incremental return, but I've been toying with adding a sort of yield-risk ladder, whereby instead of having 20% cash, have something like (I'm just throwing random #s out) 10% cash, 5% lower risk credit, 3% low grade HY, and 2% equity yield instruments (BDCs, REITS) to create a sort of cash+ yield allocation. Maybe adds 50-100 bps to yield vs just cash, but real chance for impairment with the riskier stuff.
Curious on your thoughts on using CDs as a proxy for cash/FI as they provide higher yield and are insured anyway? That has been my strategy so far.
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