Every asset has a value. Details of valuation, however, could vary from case to case. Investors value equities and various indices on the basis of their respective sectors and performance.
Fund managers, while taking such alignment calls, prefer to keep cash/liquid funds in a portfolio sometimes during uncertain situations in which it becomes hard to predict market movement. Cash calls in any situation could cause some underperformance to the portfolio/fund for 3 to 6 months. In the long run, however, it helps stabilize a portfolio.
So, when does a situation for cash call arise?
Very high market valuation
Portfolio managers take cash calls in over-valued or hyper-valued markets. Most fund managers set valuation limits to indices and sectors to make entry and exit decisions. During the fourth quarter of Calendar Year 2007, market valuation reached above 6.00 times price-to-book (PTB) value, which means the market was trading at six times its net worth against an average is 3.00 to 3.25 times. It was a strong sell call for most fund managers and few preferred to take cash calls, which saved their portfolios during the market crash that followed.
Similarly, after the stocks crash in 2008, the market reached a valuation of 2.5 times PTB, which was significantly lower than the long-term average. It was a strong entry call in the market.
India and other emerging markets are growing economies and thus carry a valuation premium over developed markets; every market oscillates within a limit and investors set those limits on the basis of their comfort zone. This helps decide the cash limit in a portfolio.
Uncertain macroeconomic conditions
Countries often witness divergence between stock market performance and economic data. Such scenarios create confusion and future uncertainty in the short-term to mid-term. For example, when a country is struggling on economic indicators such as export, GDP growth and unemployment; its indices operate at moderate valuations. In this kind of a situation, it is ideally better to wait, because quarterly earnings could drag market performance.
In such cases, some fund managers prefer to sit on cash Countries often witness divergence between stock market performance and economic data. Such scenarios create confusion and future uncertainty in the short-term to mid-term. For example, when a country is struggling on economic indicators such as export, GDP growth and unemployment; its indices operate at moderate valuations. Ideally, in this kind of a situation, it is better to wait, because quarterly earnings could drag market performance. Some fund managers rather prefer to sit on cash or liquid funds.
Abnormal situations
Abnormal conditions such as war or natural calamity can impact equity markets and keep the indices under pressure for several years. In such situations, fund managers look for other options or simply stay in cash and wait to tap opportunities. This kind of situations can keep the market depressed for a longer period.
To sum up
Cash calls in portfolio management could lead to underperformance in short to medium terms, but it has potential to work well in the long run.
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