High Cash Allocations Not Always Bad

Mark Gorzycki	Mahesh Kashyup

Mark Gorzycki and Mahesh Kashyap are the co-founders of OVTLYR (pronounced “outlier”), a platform that is designed to deliver timely behavioral insights on the depth and breadth of the U.S. public equity markets.

Their portfolio solution can, at times, recommend a high allocation to cash under certain circumstances. With cash allocations in the limelight due to the filing of a class action lawsuit against Charles Schwab, the OVTLYR team spoke with ETF.com to outline their case for why high cash allocations are not necessarily a sign of malpractice.

The following transcript has been edited for clarity and brevity.

ETF.com: What is the OVTLYR Portfolio Solution?

Mark Gorzycki: Right now, investors typically have two sources of information they can rely on. You have your fundamental side, which can be very concrete but greatly delayed, and on the other side, you have technical data.

We focus on the behavioral side of the market. We're specifically looking into psychographic information, and then we use that information to feed our own deep game theory models. That gives us a picture of what rationality looks like on a particular asset, and we aggregate that up to the portfolio level.

So what about efficient markets? We just have a slightly different definition around what's considered efficient when you take into account that people are not highly rational.

My biggest issue with efficient markets is not the broader claims. It's with the requirement of rational participants. Someone on an average day may make 40,000 different decisions. Only a handful of those require real analytical thought. Biases work their way into every learned decision we make.

So even when we bring in something as complex as making investment decisions, we have limitations to our rationality. And that, by definition, creates irrationality.

What we end up seeing is not a state of constant rationality on the market from rational participants, but the exact opposite—constant irrationality.

ETF.com: Under certain circumstances, your product will recommend a high allocation to cash. What type of market environment would result in that recommendation?

Gorzycki: If we're experiencing an irrational upside to an asset we're holding, that creates opportunities to rebalance elsewhere, because we're not expecting that irrationality to continue. In a case like that, that would be the equivalent of selling off one asset and looking for opportunities elsewhere.

The opposite is true. If we're seeing irrationality into the downside, we really try to behave as a contrarian indicator and allocate more strongly into those areas.

With that as a baseline, a situation where you might find very large allocations to cash would be those where there has been some irrational exuberance.

Mahesh Kashyap: You’ve heard, "Be fearful when the market is greedy; be greedy when the market is fearful." Investors do the opposite: They try to sell off going down, and then when it’s running up, everybody tries to buy in.

Based on that, when the market is fearful, you’ll see more allocation on those assets. When the market is greedy, we look into the opportunities elsewhere by either getting out of those positions or reducing the size of the positions. Then you may see the cash position going up and down, but that doesn't mean we’re trying to stay out of the market.

We’re very opportune when we’re building these allocations, and we stick to our philosophy of being greedy when the market is fearful, and being fearful when the market is greedy.

ETF.com: When people talk about a high cash allocation, they generally talk about it negatively due to the drag on performance. What are the advantages of having that higher cash allocation within the portfolio?

Gorzycki: There are situational benefits. They’re right if you're talking a long-term buy-and-hold portfolio that’s going to hold 25% in cash; you're effectively hamstringing that portfolio by a quarter of what it otherwise could generate. If you have a slightly more active approach [with] regular rebalancing and you allow for that position to fluctuate, if you can be efficient in capturing other opportunities as they present themselves, you're really limiting downside.

But you have to identify places to go. That's why we lean so heavily on the behavioral side. It seems to give a more timely representation of what actually manifests on the market.

ETF.com: It effectively sounds like a way to try and time the market, and that's contrary to most investing advice.

Gorzycki: There’s an element of picking the right asset at the right times which is, by definition, market timing. But there’s a difference between a day trader trying to time the market versus something more akin to regular rebalancing.

Kashyap: We’re focused on how we can build a model that can effectively try to identify those pockets of fear and greed. Our goal is to help make improvements to the current portfolio by making the right decisions.

Gorzycki: Let’s take something like dollar-cost averaging. If you're objective about it, it's timing the market. You're just timing it in a regular interval.

When you make that allocation, it’s very effective in making sure you’re never going to get the best price, but you’re never going to get the worst price. But you've still got to know where to go.

You can buy a broad index product [like] SPY and pay 9 basis points and you'll probably be fine in the long run. If you want to have a little bit more control over drawdown prevention, that's really where we start to show our worth.

ETF.com: Cash allocations within a portfolio have come into focus recently due to Charles Schwab facing the potential class action lawsuit. But you’ve argued that this high cash allocation isn't necessarily a sign of malpractice on Schwab's part. Do you think the industry will eventually view cash in this more tactical way?

Gorzycki: I’d certainly hope they continue in the direction of incorporating elements of behavioral finance. Advisors are taking it on themselves to talk their clients off cliffs when they're about to do something foolish. That’s one side of the coin that absolutely should be addressed.

The other side of the coin is all the people who aren't the advisors' clients who are still interacting on the market and may not be receiving the same advice; they may be receiving contrary advice. Those can create opportunities for the advisors' clients.

As far as cash rotation, if that presents itself as an element of the return of active management, that makes a lot of sense. It may not be expressed as cash. You may have cashlike assets, you may have entirely different asset classes, but conceptually, it makes a lot of sense to make a comeback.

Kashyap: If you noticed during COVID, that March time frame last year, advisors were putting posts on LinkedIn [saying], "Hey, don't worry about it; it will pass. Just keep on holding." By the time that event lasted for a few weeks, overall portfolios were down literally 30-40%.

You saw that big drawdown and now you need time to catch up. Yes, the market will convert faster than others, but that event is very detrimental for the end client.

Gorzycki: I lost count of all the advisors I was seeing on places like LinkedIn: "Your investment horizon hasn't changed; neither should your investments.” This was when the S&P was down 6 points, give or take. A few weeks later, you couldn't turn on the TV on any financial news channel and not hear someone talking about, “Is this a recession or a depression?”

There was a lot of uncertainty, and markets don't like uncertainty. More recently, the conversation has shifted to things like inflation versus deflation. There's always something to be uncertain about.

Our perspective is [that] we may not know when the absolute top is in or when the bottom is in. But there's a lot of uncertainty that's presenting itself that’s affecting behaviors. We can take that and say, maybe it takes off from here and goes on a crazy rally and we'll have to sit out the first leg of it. But it's better than being involved in the massive drawdown.

Kashyap: And that's where we feel these cash positions—for us, at least—work wonders.