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US corporate cash holdings have risen to record highs in recent years, both outright and as a percentage of net worth. A majority of that excess cash is on the balance sheets of the large tech companies. With the Covid-19 shock having dampened near-term investment prospects, it is unlikely that this cash is deployed soon. Undoubtedly some of the cash will be used for buybacks, but for the cash remaining, will firms continue to accept close to zero percent returns and expose themselves to a further decline in the USD? In most cases, we would expect them to seek out some alternatives.
The growing cash pile is certain to be a hot topic in corporate boardrooms. Some large corporations, such as Apple, have been running what amount to internal investment funds for years. Other tech giants are well-known financiers of start-ups, either directly or via investments in venture capital firms.
For the more risk-averse corporate boards, however, investing excess cash in other companies’ securities may not seem the best idea. In such cases, cash is likely to be held in some combination of bank deposits, money-market funds, or government securities. The problem here, however, is that with rates on cash holdings effectively zero and possibly going negative at some point, cash holdings become an automatic drag on earnings.
Corporate treasurers are now looking at under 1% annual potential returns – fixed income price appreciation returns should be minimal with the Fed wanting to avoid negative rates – combined with a potentially further depreciating USD (see Macro Hive’s recent podcast with renowned economist Stephen Roach) for companies that have large international businesses. If you are one of those corporate treasurers, why not look now to diversify into other assets with better potential long-term returns, albeit with somewhat higher volatility?
It is against this backdrop that MicroStrategy (MSTR:US) recently announced that it is diversifying its corporate cash pile into Bitcoin. As Michael Saylor, CEO of MicroStrategy Incorporated, stated in a recent press release:
‘Our investment in Bitcoin is part of our new capital allocation strategy, which seeks to maximize long-term value for our shareholders…This investment reflects our belief that Bitcoin, as the world’s most widely-adopted cryptocurrency, is a dependable store of value and an attractive investment asset with more long-term appreciation potential than holding cash… MicroStrategy has recognized Bitcoin as a legitimate investment asset that can be superior to cash and accordingly has made Bitcoin the principal holding in its treasury reserve strategy.
…Our decision to invest in Bitcoin at this time was driven in part by a confluence of macro factors affecting the economic and business landscape that we believe is creating long-term risks for our corporate treasury program—risks that should be addressed proactively…We believe that, together, these and other factors may well have a significant depreciating effect on the long-term real value of fiat currencies and many other conventional asset types, including many of the assets traditionally held as part of corporate treasury operations.…MicroStrategy believes digital transformation has quickened amid rapidly shifting market requirements. These dynamics have many corporations rethinking their offerings, operations, and systems, as well as their balance sheets and financial strategies.’
MicroStrategy is not the first listed US company to announce publicly a strategic allocation to bitcoin. Back in 2014, erstwhile Overstock CEO Patrick Byrne announced that the company was not only accepting bitcoin for online purchases but allocating $200mn to Medici Ventures, a bitcoin and blockchain investment firm. While not exactly the same as holding bitcoin directly, the move was clearly intended to gain exposure to the leading cryptocurrency. Overstock (OSTK:US) remains heavily involved in bitcoin and blockchain development projects today, with the current CEO recently stating that ‘blockchain is the future’.
The largest corporate cash balances are primarily in the biggest tech companies. Many of the earliest adopters of investing in Bitcoin and other cryptocurrencies have been developers at some of these firms. Much of the senior management is already well versed in the crypto universe, including Facebook, where they have been trying to launch their own coin. It does not seem too much of a stretch to see Facebook management deciding to take a part of their $50bn+ cash reserves and diversify into cryptocurrencies, among other alternatives.
It might seem natural for a tech company to see Bitcoin and other cryptocurrencies as an alternative to cash, but it would certainly be a stretch for a more traditional corporation. However, the basic reasoning, that ‘fiat currencies and many other conventional asset types’ could be at risk from the most aggressive peacetime fiscal and monetary policy mix in history (and not only in the US but in most major economies) is entirely sound in our opinion.
So what if more traditional corporations nevertheless begin to look for a low-risk way to diversify out of cash? If not bitcoin, what might they consider instead?
Here, too, we have a recent example: last week, Warren Buffett’s Berkshire Hathaway, known for investing almost exclusively in traditional industries, released its quarterly 13-K filing, which showed that they have taken a stake in Barrick, the second US-listed gold miner. Owning a gold miner is not quite the same thing as owning the metal itself, but as a major producer with proven resources in safe jurisdictions, owning Barrick comes awfully close.
Given that Buffett is hailed the world over as one of the greatest investors of his or any other modern generation, this decision has made theheadlines. But as corporate boards are often slow to revise or otherwise change their Treasury policies, it could be months before one or more major corporations choose to follow Buffett’s lead and diversify some of their cash holdings into gold or gold-related securities in some way, as a hedge against dollar or general fiat currency depreciation.
Looking beyond the boardroom, however, Buffet’s decision to move into gold is almost certain to have a general impact on institutional investors, in particular among the value crowd. Indeed, with the price of gold now over $2000/oz, many gold mining companies offer the sort of deep value that Buffet has always sought out for Berkshire’s portfolio.
Finally, unlike cash, and indeed unlike all financial assets, the supply of precious metals is finite and highly inelastic. Central banks create cash reserves as desired, which are subsequently transmitted through to the economy by the banking and financial system. Corporations issue debt and equities as required to grow and expand their operations. Metals are therefore a natural diversifier vis-à-vis that which is elastic in supply, and in recent years, extremely so.
US corporations are sitting on a record amount of cash and securities, unless they are preparing to allocate all to buybacks or dividends, it makes logical sense to allocate some to metals and possibly Bitcoin. The Federal Reserve’s recent move of putting short-term interest rates near zero and the beginning of a possible long-term depreciation trend in the USD should combine to pressure corporate treasurer’s to consider diversifying out of cash holdings into higher-returning assets like gold and Bitcoin.
The interesting dynamic for both is the high inelasticity of supply, even a small shift in the overall investment demand function for precious metals implies large increases in price. By some estimates, investors only hold about 1-2% of their assets in precious metals. Were that to increase to 5-10%, then precious metal prices would need to increase by five-fold or more. Where Buffet sees deep value, others might see a speculative play. In either case, notwithstanding a strong recent run, the bull market in precious metals may still be in the early stages, with highly asymmetric upside potential.
There has always been a question of how hedge funds and asset managers make money. By exploiting a comprehensive regulatory database, a new Bank of England working paper finds that these investors have made abnormal returns in bond markets since 2011. They have done so by obtaining a competitive edge from observing other investors, responding quickly to macroeconomic news and correctly forecasting macroeconomic fundamentals.
The chart below captures the predictive power of fund managers concisely. It shows the event-time cumulative returns of the long-short portfolios (long on the top tercile and short on the bottom tercile of government bonds) sorted by daily order flows of the two investor types. We can see that hedge fund trading positively forecasts bond returns in the short run followed by a strong reversal in the subsequent month. Mutual fund order flows, on the other hand, positively forecast bond returns in the subsequent two months.
The paper also shows that hedge funds and mutual funds have a significant advantage over other market participants in collecting, processing, and trading on information that is relevant for future gilt returns. In particular, the findings highlight the differences in the two groups’ approaches to earning abnormal returns in the government bond market.
A. HFs gain from both trading ahead of other investors and quick responses to the arrival of macroeconomic news.
B. MFs profit from their ability to understand and forecast macroeconomic fundamentals.
Through their active trading, these professional managers help to impound value-relevant information into gilt yields and expedite the price discovery process in one of the world’s most important financial markets.
There are two competing theories the literature puts forwards for variations in bond yields:
I. The traditional view: Monetary policy announcements and the arrival of public information drive the main source of variation in the terms structure of interest rates. According to this view, trading in government bond markets is mostly due to rebalancing and hedging needs and is unlikely to have a large, persistent effect on bond yields.
II. The alternative view: Heterogeneity in investor beliefs generate variations. This stems from differences in investors’ access to information and their ability to relate publicly available economic fundamentals to the term structure of government bond yields. An immediate prediction of this view is that as long as learning is imperfect, trading of the better informed should persistently outperform that of the less informed.
The BoE working paper focuses on the second channel. A large empirical literature on institutional trading has so far found little evidence that professional money managers are able to earn significant abnormal returns in stock and corporate bond markets. Instead, this research asks whether a subset of non-dealer institutions have superior knowledge about future government bond returns.
On this front, the authors find:
‘Daily hedge fund trading positively forecasts gilt returns in the following one to five days, which is then fully reversed in the following month.’
‘Mutual fund trading also positively predicts gilt returns, but over a longer horizon of one to two months. This return pattern does not revert in the following year.’
The work then goes on to address why fund trading forecasts government bond returns, and for this they build on recent theoretical work by Farboodi and Veldkamp (2019). They postulate that arbitrageurs can engage in two types of activities: (i) to predict and trade ahead of other investors’ demand, and (ii) to learn about future asset values in an accurate and efficient manner (more so than the average investor in the market).
Both mechanisms are examined, and the authors find:
‘Part of short-term return predictability is due to hedge funds’ ability to anticipate future demand of other investors’.
‘It is partly due to mutual funds’ ability to forecast changes in short-term interest rates’.
The study uses the ZEN database, a comprehensive regulatory dataset maintained by FCA containing all secondary market trades in UK government bonds (gilts) by all FCA-regulated financial institutions. Given that all gilt dealers are UK-domiciled and hence FCA-regulated institutions, the ZEN database effectively covers the entire trading activity in the UK government bond market.
The database offers three main advantages:
The sample period spans August 2011 to December 2017. They only keep bonds with a time-to-maturity longer than one year and exclude inflation-indexed gilts from the sample. The granularity and completeness of the data enable them to systematically analyse the extent to which any investors have a competitive advantage in this market and, furthermore, are able to profit from their information edge.
The final sample consists of 55 gilts covering nearly all gilt transactions. The majority of guilt trades take place in the inter-dealer market. The following chart shows the market share in the UK government bond market.
For the investigation of whether funds are able to use value-relevant public information efficiently, the authors focus on announcements of UK inflation and labour statistics, and the Monetary Policy Committee (MPC) meetings. MPC meeting dates are collected from the Bank of England, and the UK Office for National Statistics publishes the other macro-announcement dates.
Finally, to calculate risk-adjusted bond returns, they construct three tradable factors mimicking the level, slope, and curvature factors of the term structure of government bond yields. For the level factor, they use the value-weighted average return of all available gilts. For the slope factor, they use the return differential between the twenty-year gilt and the one-year gilt. The curvature factor is the average return of the twenty-year and one-year gilts, minus that of the ten-year gilt.
This section is divisible into three parts. One, results on the predictability of HF/MF trading on gilt returns. Two, the ability of HFs/MFs to predict other investors’ returns. Three, the ability of HFs/MFs to learn from value-relevant information and respond to it more efficiently than other market participants.
They find that both HFs and MFs have significant information advantages in the gilt market. There is a strong positive correlation between HF/MF trading and contemporaneous gild returns – gilts heavily collectively bought by hedge funds and mutual funds on a particular day outperform those heavily sold by 1.82 bps. Specifically:
2. The authors regress order flows of hedge funds in the same bond in the previous week onto aggregate order flows of an investor type (mutual funds, non-dealer banks, and ICPFs) in a bond in the next five days. They find:
3. Finally, the paper repeats the return predictability test of HF/MF trading separately for macro-announcement days and non-announcement days. Again, they sort all gilts into terciles based on hedge fund order flows on the day prior to the announcement. They then track the performance of the long-short portfolio on the announcement day. In a time-series regression setting, controlling for known predictors of future interest rates, they find for:
Both hedge funds and mutual funds are informed investors in the gilt market. The former have short-term predictive power which can be attributed to their trading ahead of other investors’ predictable order flow. Mutual funds also positively predict bond returns, but over a horizon longer than one to two months. The superior performance of mutual funds is partly due to their ability to forecast future movements in short-term interest rates.
The punchline: nimble hedge funds are good at trading ahead of other investors’ future demand; mutual funds are instead more concerned with economic fundamentals.
To view the full paper – click here