With the economy continuing to struggle, and with inflation low–maybe too low–the Federal Reserve will likely keep short rates low for an extended period, perhaps years. In this environment, advisors need to identify risk-conscious strategies that can enhance the performance of the cash portion of an investment portfolio.
When investors construct investment portfolios, they usually devote considerable attention to determining the optimal allocation between stocks and bonds. By contrast, decisions about the cash portion of an investment portfolio are seldom subjected to the same degree of scrutiny. When investors do think about the cash allocation, they tend to consider only a narrow range of traditional investment choices, and it seems that they focus more on equities, which frequently appear at the forefront of the news. Nevertheless, a balanced financial plan should include elements of all three asset classes–equities, bonds, and cash–in order to maximize risk-adjusted returns in an investor’s portfolio.
Financial planners and consultants generally recommend keeping the equivalent of three to six months expenses in a cash reserve. The exact amount that an individual, family, or institution should maintain in a reserve or emergency fund depends on factors such as the outlook for income stability and projected expenses.
The primary goals of a cash portfolio are capital preservation, liquidity, and a competitive rate of return. Money that someone truly needs immediately should be invested in money market accounts, short-term certificates of deposit, or bank savings accounts. Money market funds and bank savings deposits provide principal protection and liquidity, but returns are low. Longer-term CDs and government savings bonds offer a higher yield than money market funds, but this usually is offset by less liquidity in the form of a penalty for cashing out early. If tax avoidance is a priority, then tax-exempt money market funds and short duration municipal debt funds are another alternative.
As of the end of 2002, $2.3 trillion was invested in money market mutual funds and another $2.5 trillion in money market instruments, including bank accounts and bank CDs, according to the Investment Company Institute. This is evidence that many investors believe that cash is the place for a good night’s sleep. Money funds are designed to provide perfect liquidity and to trade with no loss of share value. Nevertheless, there is a range of conservative investment options that over time perform much better than money market funds for investors with a slightly longer time horizon.
Perfect liquidity has its benefits, but it is the enemy of higher returns. Over the long term, it should not matter to investors if their liquid reserves were to fluctuate between 98 to 102 cents on the dollar, as long as they averaged 100. By accepting more volatility, investors can significantly increase their potential for higher returns.
By considering a broader range of short-term investment strategies, investors can exert an increasingly significant impact on portfolio returns. These enhanced cash strategies are designed to improve on returns provided by typical money market vehicles while preserving principal and providing daily liquidity. Strategies that fall in the Lipper “ultrashort obligations” category seek to capture excess returns related to several structural inefficiencies within the short end of the fixed-income yield curve. Lipper “short investment- grade” strategies use a similar approach, but are more appropriate for investors who can accept slightly greater price volatility in pursuit of higher incremental returns. Enhanced cash strategies have greatly outperformed common money market and cash equivalent benchmarks.
When cash is not necessary for immediate needs, these strategies should provide a yield cushion and higher long-term total returns with a minimal increase in risk (price volatility) relative to money market investments. Table 1 shows some examples of such strategies.
Enhanced cash investments are designed to be conservative and diversified portfolios that use multiple concurrent strategies in an attempt to generate improved returns over those available in money markets. A significant portion is invested in the same high-quality, short-term securities that are the standard fare of traditional money market funds, such as CDs, Treasury bills and commercial paper. This is combined with an expanded investment opportunity set to generate excess returns over money market strategies.
Structurally, enhanced cash portfolios seek to capture excess returns by investing in four strategies embedded in the short end of the fixed-income yield curve:
o A term premium may accrue to investors for holding securities with slightly longer maturities than those of money market instruments. Increasing the duration of a cash portfolio modestly beyond the typical three-month duration of traditional money market funds has the potential to significantly improve portfolio performance without materially increasing the likelihood of negative returns.
o A credit premium may be obtained by holding a portfolio of securities with diversified credit quality. Blending high-quality AAA and AA holdings with carefully selected bonds rated below AA allows the portfolio to increase yield and improve diversification.
o A liquidity premium may offer incremental yield for holding bonds with wider bid/ask spreads. The inclusion of some higher-yielding but slightly less liquid securities such as floating-rate securities and adjustable-rate mortgages in the portfolio may provide another source of excess return.
o A volatility premium may be available to investors who can tolerate increased principal fluctuations. Many investors pay an excess premium for price stability, as implied short-term market volatility generally is higher than actual realized volatility.
And Now, the Results…
Enhanced cash strategies are structured to generate excess returns over money markets over long periods. Excess returns can be measured in a number of ways. Historically, ultrashort strategies have provided a yield cushion over money markets of 50 to 100 basis points and short investment-grade strategies had an even greater yield advantage of 150 to 250 basis points. Table 2 demonstrates the current yield cushion for these strategies. The cushion is derived from a premium in yield for assuming a modest increase in duration and from active investment in the broader universe of securities available to investors who are not limited by money market restrictions. The yield cushion has the potential to enhance returns and provide a buffer against potential adverse fixed- income price performance.
Yield is not the only measure to use in evaluating enhanced cash strategies, however In general, extended duration and a broader opportunity set of investments may provide enhanced returns over money market strategies as demonstrated in Table 3.