The global economy is wobbly. Many investors are seeking safe refuge from market uncertainty in cash. Yet holding on to too much for too long may not be wise because of factors like inflation and opportunity cost.
In any portfolio mix, cash has a role. As a hedge against market volatility and a balance to other less liquid assets, cash is irreplaceable. Many investors park wealth in cash as an emergency reserve. Others hold it as they wait for unexpected investment opportunities or while they’re shifting strategies.
These are all solid reasons. But our research finds 68% of investors agree with the statement, “I feel much less confident about making investment decisions now than in the past.” Further, more than two-thirds surveyed say they expect a negative return from increasing their cash holdings.
The cost of cash
Pure cash is 100% liquid. Also, cash is transparent—there are no complicated structures to explain. Short-term instruments like GICs, T-bills, commercial paper and other cash equivalents offer similar benefits, though for most investors the only way into these markets is through money market funds. In doing so, they take on more risk and higher yields than they would with pure cash, but incur fees and reduce liquidity.
In the short term, cash is probably the safest vehicle when it comes to investment risk, but over time, taxes and inflation will reduce returns. (see “Cash provides negative real returns,” below) Our analysis of compound annual returns between 1926-2011 shows cash had a CAR of 3.6%, but factor in inflation and the return drops to 0.6%. Add in taxes, and the compound annual return of cash dips into negative territory, at -0.8%. Meanwhile, stocks and bonds have performed much better.
Cash provides negative real returns
Over a 20-year retirement, cash will lose nearly half its purchasing power—even at a low inflation rate of 3%. Granted, inflation is currently lower than 3%. But yields on cash investments, which are heavily correlated to overnight rates set by the central bank, are also at historical lows.
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It appears real short-term yields will remain low for some time, and keep the relative cost of cash high. So help investors with large amounts of cash consider alternative asset classes.
1. Consider dividend stocks
Many companies around the world are sitting on record piles of cash. They’re paying out a historically low percentage of revenues in dividends, but the yields on many stock markets are still outstripping those of government bonds.
As well, the high-cash-reserve/low-dividend equation suggests that companies have capacity to increase dividends in future.
And, while inflation erodes the purchasing power of cash and safe-haven bonds, corporate profits—and therefore dividends—have historically grown faster than the rate of inflation. As a result, fairly valued stocks in good companies provide potential for capital appreciation.
2. Look at fixed income
For investors holding cash as part of a low-duration strategy, floating-rate notes provide a simple alternative that can give them access to greater yield, while minimizing exposure to interest-rate risk.
As the name implies, floating-rate notes don’t pay a fixed-rate coupon, but rather a floating-rate coupon pegged to a specified market interest rate that is adjusted monthly or quarterly, such as the 3-Month Bankers Acceptance Rate.
Durations (a bond’s change in value based on a change in interest rates) are low. The DEX Floating Rate Note Index weighted average duration, for instance, is only 0.13 years as of November 2, 2012.
As a result, these notes are less subject to interest rate risk than short-duration fixed-rate bonds—if inflation starts moving up, floating-rate notes are impacted less by rising rates and falling bond values. ETFs can provide a liquid, cost-effective means to access these instruments, and yields can outpace those of cash.
3. Use corporate bonds
With borrowing costs low, and bank lending still tight, many solid companies are turning to bond markets to raise capital.
However, the yield spreads between corporate debt and benchmark government bonds are at historical highs.
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Current spreads suggest the market is undervaluing solid fundamentals. That is pushing corporate yields higher, and presenting opportunities to investors looking for ways to put their cash to work.
4. Always diversify
Mixing and matching ETFs to suit an investor’s profile can be an efficient, cost-effective approach to cash replacement. For instance, a short-duration cash replacement strategy could involve transferring cash holdings into either a floating-rate-note index fund or a short-term corporate bond.