It went on to warn investors that these cash holdings “are a potentially bearish indicator.” It also described how several large pension plans had significantly raised their cash holdings. For example, New York City’s plan has tripled its cash holdings during the past 18 months, and the South Dakota Retirement System raised its cash holdings to more than 20% through the middle of last year.
Cash Balances Predict Market Returns?
We’ll begin with a look at whether cash balances are a good predictor of future market returns. If they are, we should expect to observe low cash balances at market peaks and high cash balances at market bottoms. While now a bit dated, a study by Goldman Sachs examined mutual fund cash holdings from 1970 to 1989. They found that mutual fund managers miscalled all nine major turning points. It’s hard to get all nine turning points wrong if you tried! We can also look at results from mutual funds that tactically allocate.
Tactical Asset Allocation
Although a given benchmark might be 60% S&P 500 Index and 40% Lehman Bond Index, the manager might be allowed to have his or her allocations range from 50% to 5% for equities, 20% to 50% for bonds, and 0% to 45% for cash.
In reality, TAA is just a fancy name for market timing. By giving it an impressive name, however, Wall Street seems able to charge high fees. Let’s see if the high fees are actually worth the price of admission. A study found that for the 12 years ending 1997, the S&P 500 on a total return basis rose 734%, but the average equity fund returned just 589%. The average return for 186 TAA funds was a mere 384%, or roughly half the return of the S&P 500 Index.
Morningstar then updated the study through the end of 2011. They compared the returns of TAA funds to Vanguard’s Balanced Index Fund (VBINX), which passively invests its assets in a 60/40 stock/bond mix. The following is a summary of their conclusions:
- Very few TAA funds generated better risk-adjusted returns than VBINX.
- Just 9 of the 112 TAA funds in existence over the period from August 2010 through December 2011 had higher Sharpe ratios (a measure of risk-adjusted returns).
- Only 27 of the funds experienced a smaller maximum drawdown (the majority experienced larger peak-to-trough declines).
- Only 14 of the 81 tactical funds in existence since October 2007 posted lower maximum drawdowns during the 2008 financial crisis, the spring/summer 2010 correction, and the recent European debt-related downturn. Put another way, only 17% of the funds consistently provided the insurance for which investors were paying.
And here’s additional evidence from a more recent study by Morningstar. Over the three years ending July 2014, TAA funds gained an annual average of 7.8%, or 3.8% per year behind their benchmarks.
They also confirmed that past success in overcoming this hurdle does not ensure future success. Vanguard was able to reach this conclusion despite the fact that the data was biased in favor of active managers because it contained survivorship bias.
And in case you think pension plans are better than mutual funds at the game of TAA, Charles Ellis, in his book, “Investment Policy,” cited a study on the performance of 100 pension plans that utilized TAA and found that not one single plan benefited from their efforts. Not one. Even randomly we would have expected some to succeed. Yet, none did.
The Bottom Line
Sign up for Advisor Access
Receive email updates about best performers, news, CE accredited webcasts and more.
Let’s face it, the words we use everyday matter! Our content for this...