From the December 2008 issue of Wealth Manager Web • Subscribe!


In the 1976 movie "Marathon Man," Dustin Hoffman is being tortured by a Nazi war criminal played by Laurence Olivier, who asks him repeatedly, "Is it safe?" Hoffman, who doesn't understand the question, is therefore, unable to provide an answer.

Today, investors are asking the same question about the capital markets, and the answer--at least from individual investors--is that cash, in the form of money market funds and short-term U.S. Treasury securities, provides safety.

But regardless of how the economic crisis unfolds, cash almost certainly offers the least attractive risk-adjusted returns.

The Financial Research Corporation (FRC) reported that investors withdrew $21.9 billion from stock and bond funds (excluding money markets) in September. International/global equity funds suffered the worst, experiencing $27.6 billion in net outflows. U.S. equity showed surprising resilience, with net inflows of $12.8 billion. At the same time, money market fund balances are at an all-time high--well over $3 trillion.

Morningstar also reported record fund withdrawals in September--the largest one-month outflow they have seen since they began tracking this data in January of 2000. Moreover, Morningstar expects a "more severe" withdrawal to occur in October, once this data is reported.

In the aggregate, it seems investors have had enough of the recent volatility and would rather hold cash.

However, advisors are not exhibiting similar tendencies. According to data from the Advisor Perspectives (AP) universe, they remain invested in mutual funds.

Advisors' cash allocations have increased slightly, roughly in line with the decrease in value of their non-cash positions. There has been no significant exodus from mutual funds; the decreases shown here roughly parallel decreases in asset values. The AP Universe comprises approximately $50 billion of assets managed by registered investment advisors for high- and ultra-high-net-worth investors. The data shows that advisors have been keeping consistent asset allocations and rebalancing during this highly turbulent period.

Is a flight to safety the right move? Are individual investors correct as they stuff assets into the capital market equivalent of a mattress? Or are advisors being too closed-minded in their refusal to adopt a more conservative asset allocation?

Every academic study that has looked at the flow of dollars into and out of mutual funds has reached the same conclusion: In the aggregate, investors chase performance. They pull money out of funds at exactly the wrong time--after a period of market declines. They flow money into funds after a period of increasing prices.

In these unique times, it is reasonable to question this conventional wisdom. Nonetheless, the arguments against cash remain strong. All signs point to mountainous government deficits which will be funded with increased money supply--a sure sign of impending inflation. Many economists, including Brian Wesbury, chief economist at First Trust Advisors LP headquartered in Lisle, Ill., regard inflation as the number-one threat to the capital markets.

In an inflationary environment, cash is guaranteed to fail on a risk-adjusted basis. Today, even with relatively modest inflation, short-term Treasury securities have negative real yields. Equities might be a good asset class to hold as inflation unfolds, but Treasury Inflation Protected Securities (TIPS) would be an even better alternative for a risk-averse investor. A cash investor, waiting for the onset of inflation, would have to time the shift to equities perfectly because, as studies have shown, missing the two or three best days of equity returns can destroy long-term performance. TIPS provide the sure-fire hedge against inflation.

But inflation is not a forgone conclusion, at least in the short term. NYU professor Nouriel Roubini, who gained fame for being among the first to correctly predict the subprime crisis, now says the biggest threat faced by the economy is stag-deflation--slow growth combined with a deflation in prices.

Deflation changes the equation, and cash becomes a more attractive asset class. But even better than cash might be nominal bonds. High grade corporate bond spreads are at all-time highs (at least as we went to press in early November), promising bond investors terrific risk-adjusted returns in a deflationary environment.

The Fed can be counted on to fight deflation even more aggressively than inflation. The tools it would use--increasing the money supply--would make it even more likely that a highly inflationary environment would follow a deflationary period, and possibly unfold at a very rapid pace. So, positioning portfolios now for deflation requires the nimbleness to shift allocations once expectations shift to reflect a containment of deflation.

For Laurence Olivier in "Marathon Man," there were no obvious answers to what was safe. For today's investors, the data strongly suggests that the traditional safe investment--cash--is not safe. Olivier ultimately makes the wrong choice, and his cache of diamonds is swept away in the climatic scene. Holding short-term Treasury securities and money market funds could foretell a similar fate.

Robert Huebscher ( is CEO of Advisor Perspectives (, a free online database and weekly newsletter for wealth managers and financial advisors.

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