Most of we active equity investors have a need for tactical or strategic cash holdings, monies which we expect to place in the market when we are more confident of pricing or prospects. For some, part of this can be a long-term holding, held in reserve in the event of a crash–the buying opportunity of a lifetime–while the remainder may swell or shrink over time. In reality, however, we probably end up holding more cash, on average, than is good for us.
Many years ago, in what seems like a different life, this medium or long-term cash could have been earning a decent rate of interest, even if tax and inflation took a chunk off its gross returns. Now, as we all know, even in notice or term accounts, the interest rate on these is not far off zero, and it hardly seems worth the inconvenience of accepting limited access for the marginal return. While the capital is safe if held in a bank, at least in relative terms, it still rankles knowing that the interest paid is so much less that the yield on equities.
The alternatives
In the last year or so, as equity market pricing appeared high on many measures, I have been holding more cash than usual as a form of insurance policy. I have therefore been looking at various possible homes for that cash. Of course, none of the alternatives can offer the security of cash (at least up to the bank guarantee level) or its immediate availability (assuming that there is no further banking crisis), while also providing a reasonable return. Inevitably, it is necessary to accept a trade-off.
A starting point might be gilts (bonds issued by the British government). Personally, I am not so risk-averse as to be willing to hold an asset that promises a negative return if held to maturity, even if the gross-redemption yield is marginally above zero, dealing costs will soon push it below. Over the short-term, they behave more like equities nowadays, with volatility in pricing meaning that capital losses can be significant, and there appears to be limited room for further yield falls. Although I can understand their appeal to short-term traders, they do not seem to be an appropriate safe place to park short- or medium-term money.
Looking for a reasonable level of liquidity and a better return, I considered investing on the London Stock Exchange retail corporate bonds (ORB market) system. Superficially, these looked attractive, with yields from 4 percent upwards, but there were a number of problems. Their bid-offer spreads were quite high. This was important, as most of them had a number of years to maturity, and it was likely that I would need to sell them in the secondary market in order to cash in. (New issues were fairly infrequent, so purchases would also have to be in the secondary market). The relatively high bid-offer spreads were a reflection of the relatively poor liquidity of the bonds. There were only a limited number of brokers who allowed online trading in them, so it required the inconvenience of setting up a new account. Finally, because each bond was for a single company, I would need to invest in a significant number of them to secure diversification, perhaps 20 or 30, which sounds prohibitively expensive.
Poor liquidity is, in general, a problem with all forms of corporate bonds. So, accepting that as a “price to be paid,” I considered non-quoted fixed-income assets. One growing area is peer-to-peer lending, but this also means committing money for a reasonable length of time with poor or no liquidity. I was concerned about the security offered and the need to accept a relatively modest level of due diligence. I have tentatively placed some money is Savings Stream, where individual loan propositions are selected by the lender. This is essentially bridging finance for property investments or developments, and providing a return of 12 percent. This high rate reflects the risks and the management that the investor needs to devote to examining the individual opportunities. Some knowledge of property values and trends helps and I always examine the property valuations very carefully, preferring those from the large well-established, RICS-recognised valuers. As is the nature of such things, the best propositions are typically over-subscribed and return the capital early as they re-finance at lower rates elsewhere.
In the bond/fixed interest area, I have ended up investing in Downing bonds. These are asset-backed, offering yields of more than 5 percent with reasonable Loan-to-Value ratios (typically below 70 percent) and with good cash flow projections from existing businesses to cover the interest payments. Their maturities are typically a year and, by investing my capital over the various issues over time, I will have a spacing of return of capital so that I can recycle it. This, I feel, gives me a balance of security, returns and diversification from equities. My own due diligence is limited, which avoids me being diverted from the equities market, and I rely on the “sponsors” who have experience of assessing these sorts of propositions. This makes me feel relatively comfortable.
Back to equities
One factor to remember with bonds or fixed interest investments is that the interest is quoted gross, so a significant proportion of the promised return will be paid away in tax. But, for those assets that qualify, advantage can be taken of the new tax-free allowance on interest payments. Equity yields are quoted net of basic rate tax or, at least, they were before the introduction of the new dividend tax. This tax is, however, still lower than that chargeable on interest payments, so comparable equity yields still hold an advantage–and there is a tax allowance for dividends as well.
The question that I then posed to myself was whether I could produce a “money-parking fund” in equities. Such a fund would be designed to, as far as practicable, emulate a deposit account, but produce a better income. To do this, the equities should fulfill certain criteria although, in reality, they only meet these ideals to a partial and limited extent:
- They should be very low beta. If the market does drop precipitously, I will probably suffer some loss in those circumstances–a zero beta is impossible–but I do not want to suffer as much of a capital loss as I would from my “general” equity holdings. After all, one of the ideas is to liquidate these “parked” holdings and take advantage of price weakness in the general market.
- There needs to be diversification, ideally with low co-variance between the stocks, so that even if some stocks are down, others are up. I can then minimise crystallising any capital loss if I only need to partially liquidate my holdings.
- The yields need to be reasonably high and secure. This might suggest that the stocks should offer high dividend coverage, but a low coverage (but still a minimum of one) would be acceptable depending on the security of the income.
- The stocks should have good liquidity, not just because these will be most salable, but because I will suffer the bid-offer spread in a relatively short period and that can be a significant cost (together with the brokerage fee) to be set against the returns.
- Another significant cost is stamp duty. Where there is a choice, non-U.K. domiciled stocks, with zero duty, have an advantage.
It is important to set an appropriate target for the monies held in this fund, and my benchmark is a weighted average of 5 percent. That is clearly higher than the main U.K. indices, so it implies stock-selection. Some may regard it as being too high, implying an above-average risk, but I am selecting for high yield and low growth or, in other words, my target is a 5 percent total return in the short-term. For those who feel that the yield target might put at risk the criteria of the fund, a safer figure would be 4 percent although at this level, my fixed interest investments start looking more competitive–and the equity fund is really only more attractive because of the potential liquidity and the limited protection against unexpected inflation that it might offer.
To be honest, I tend to be attracted by high yields anyway. Growth stocks can effectively roll up their return on capital, reinvesting to produce higher values still, but I like having cash coming in, which can compound by being reinvested or, in the case of this fund, spent if necessary to meet small but regular outgoings.
Diana Patterson started her career as a student nurse and, after qualifying as a staff nurse, became a ward sister. After a further two years of full-time study, she qualified as a tutor and examiner by the age of thirty. Seeking another challenge, she studied for a degree in law while still working full time. After subsequently qualifying as a solicitor, she practiced in Central London in residential and commercial property and probate. Her main interest outside work was trading in the stock market, with an intention to becoming financially independent. As soon as her portfolio returns exceeded her earnings in the day-job, she decided to invest full time. This was facilitated by the advent of the internet and the increase in freely-available information. She adopts a counter-intuitive approach, using her training in psychology, and believes that 2008 was the opportunity of a life-time. She has survived three bear markets and is in the process of assessing whether the Referendum will offer another such opportunity. You can contact her via Twitter at @DianaEPatterson.
