Keeping Your Cash Savings From Shriveling Up

Keeping Your Cash Savings From Shriveling Up

Having just lived through a couple of the most volatile stock market weeks we’ve seen in a long time, it’s natural for your thoughts to shift to capital preservation. From the 1980s through the dot com bust you could have allocated a portion of your investment portfolio to money market funds knowing that it would grow almost risk-free at a rate at least 1% above the rate of inflation. Beginning in 2002 that strategy started to unravel as short term interest rates declined almost to zero. As a result money market funds ultimately became more like safe deposit boxes for cash than as opportunities for even modest growth. Those investors that panicked after the crash of 2008 and moved what was left of their investments into the safest money market funds – those investing in U.S. treasury bills – lost on average 1.8% of the purchasing power of their investment every year since that time. Today, with the average fund returning a paltry 0.01%, it won’t take much of a bump up in inflation to further erode the purchasing power of your money market investments.

Jerome Schneider, a managing director at mutual fund company PIMCO, suggests that the solution is to switch to funds that provide more active approaches toward capital preservation. He writes in a recent article: “Ahead of the Fed’s rate actions and also the implementation of the Securities and Exchange Commission money market fund reform in 2016, we believe now is the time for investors to consider looking beyond money market funds toward active approaches for capital preservation. Alternatives, including low volatility short-term and low duration strategies, seek to preserve purchasing power, as well as capital, in an environment of increasing inflation pressures by investing in assets that may offer more yield and the potential for higher total returns in exchange for a minimal increase in risk.”

I agree with Schneider, but with the caveat that in investing there is no free lunch.  With regard to fixed income investments, the only way you can reduce interest rate risk while maintaining real (i.e. above inflation) growth is by taking on higher levels of other types of risk such as credit, currency, and/or liquidity risk. In other words, you can only generate more income by investing in funds holding bonds (1) from companies with poorer credit, (2) in countries whose currencies are expected to strengthen against the U.S. dollar, or (3) that may lock up your cash for some period of time. Of course, the higher the return, the greater the chance that the fund fails to achieve the expected return, not to mention the risk that it could lose value. And that relationship is not necessarily linear. During times when bonds yields are low, stretching for a little bit more yield can come with a pretty high downside consequence, notwithstanding the fact that bond funds are historically much less volatile than stocks.

This isn’t to suggest that there’s nothing active bond managers can do to squeeze out additional income with, as Schneider puts it, “a minimal increase in risk.” In certain types of environments (such as when yield curves are steep) a good active bond fund manager can take specific actions such as rolling down the curve to generate additional returns without adding hardly any commensurate risk. That alone bolsters his claim that actively-managed bond funds can provide better purchasing power support than index funds. But there’s only so much additional income a fund manager can generate, and those that utilize derivatives, credit default swaps, and other alternatives to leverage returns may be taking a lot more capital preservation risk than is warranted for money that might be needed in the short term.

Finding the right balance between the competing goals of purchasing power support and capital preservation is very challenging in the current era of extremely low interest rates. I would argue that on the fixed income side of your portfolio the latter goal is the more important of the two. It’s therefore very important to determine how much risk an active manager is taking before committing money to his/her fund that you will need for living expenses or other short-term goals.

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