Through 2006 and 2007, as credit spreads compressed and equity markets advanced, Seth Klarman’s Baupost Group was holding between forty and fifty per cent of its assets in cash. Baupost was a Boston fund known for its patience and its secrecy in roughly equal measure. At the time, the patience was costing it. Clients wrote. Consultants expressed concern. The fund’s relative performance, measured against benchmarks that were fully invested and rising, was uncomfortable.
Klarman’s response, in his letters to investors, was to restate the principle he had held since the fund’s founding: to require full investment at all times is to remove an important tool from the portfolio, the ability to wait patiently for compelling opportunities that may arise in the future. This was not a popular position. It required clients to accept years of lag, to listen to peers discussing the returns on investments that Baupost had declined to make, and to trust that the explanation (we do not see adequate compensation for the risk) was something other than an excuse.
Many funds that held large cash positions in 2006 and 2007 were making a forecast: that the market would fall, and soon. Klarman was making something different. He was making a pricing judgement. The available alternatives, at prevailing prices, did not clear his hurdle. Nothing about that judgement required knowing when markets would correct. It required only an honest assessment of what was on offer.
When the crisis arrived, the criticism stopped. Through 2008 and into 2009, Baupost deployed its reserves into distressed debt that had fallen to fractions of face value. Klarman bought CIT Group bonds at sixty-five cents on the dollar, generating a yield of fifteen per cent. As the situation resolved, those bonds converted to securities worth eighty cents on the dollar. The discomfort of the preceding two years had not been an error. It had been the price of admission.
Baupost was not the only institution absorbing that criticism. By the summer of 2007, the consensus view on Warren Buffett had hardened into something close to pity. Berkshire Hathaway was sitting on more than forty billion dollars in cash and Treasury bills, a figure that attracted regular commentary in the financial press, none of it flattering. The market was in its fifth year of a sustained advance. A new generation of investors had concluded, not unreasonably, that the old man from Omaha had been left behind by a world that moved faster than he did. The question asked at shareholder meetings, in research notes, in the hallways of investment conferences, was always a version of the same thing: what was he waiting for? The cash was earning almost nothing
He did not appear especially troubled by the question. In September 2008, eight days after Lehman Brothers filed for bankruptcy, Goldman Sachs placed a call to Omaha. The investment bank needed capital. Markets had seized. The terms were available only to someone who could write a cheque large enough to matter, without first becoming a seller: ten per cent per annum on five billion dollars in preferred shares, plus warrants on a further five billion in common stock at a fixed price. Berkshire’s preferred shares alone would pay Goldman five hundred million dollars a year. Buffett later noted, with evident satisfaction, that the arrangement was producing roughly $1.4 million a day.
The ‘lazy’ cash pile was not laziness at all. It was the funding instrument for the terms of a crisis, terms available only to someone who had spent years enduring the charge that they were not doing enough with their money.
There is an asymmetry in how cash is judged that shapes all conversation investment committees have about it in practice. When cash lags a rising market, the accountability is immediate. The attribution report shows the drag. The consultant’s question — politely phrased, unmistakably pointed — arrives in the next quarterly review. Why are we paying fees for this? What is the redeployment plan? The manager must answer, specifically, in writing, for the visible cost of patience.
When a fully invested portfolio falls alongside the market, the conversation is different in kind, not merely in degree. The language shifts. Markets were down broadly. The strategy behaved as expected in a difficult environment. We stayed the course. The loss is shared across the industry, and what is shared is absorbed differently from what is singular. Nobody writes a pointed letter demanding to know why the manager owned what the index owned when the index fell thirty per cent.
Being fully invested is not a virtue. It is a choice, and a choice with costs that are real but deferred.
Cash has a cost. The premium it exacts is real and should be acknowledged without flinching: the foregone return of not owning the next-best alternative, plus whatever purchasing power inflation erodes. In a portfolio holding ten per cent in cash at four per cent, against a risk asset returning twelve per cent, the drag for the year is approximately eighty basis points. That number belongs in every committee discussion that raises the subject.
But the ledger has a second side that rarely appears in attribution reports. If the same risk asset falls twenty per cent, the portfolio with cash avoids two percentage points of loss. More than that, it retains the capacity to act. It can buy more of the same asset at lower prices, or take advantage of dislocations elsewhere, without first needing to raise liquidity by selling something else at a loss.
The question is not whether cash outperforms. It is whether the option to act, valued honestly, is worth the premium paid to hold it. When alternatives offer generous compensation for their downside, when entry terms are compelling and the dispersion of outcomes is narrow, the option is less valuable. Own the assets. When alternatives offer thin compensation for wide uncertainty, when crowded positioning makes exits unreliable and correlations are likely to rise under stress, the option becomes more valuable. Hold cash.
