What a (Cash) Drag: Institutional Investors and ETF Cash Equitization

Kevin Feldman:  How institutional investors handle “cash drag”- and how you can, too.  I recently blogged about a report from Greenwich Associates that showed institutional ETF usage is on the rise.  One of the primary ETF strategies in that space?  Cash equitization, an approach that’s little-used (and perhaps even little-known) in the individual investor realm.  Reading through the report and all the subsequent media coverage got me thinking – why aren’t more retail investors using ETFs to equitize their cash?

At first glance, cash equitization using an ETF is pretty straightforward.  As opposed to carrying a significant cash position, an investor simply selects an ETF that closely approximates their target risk and asset class exposure to remain invested in the market. Typically institutional investors will implement a cash equitization strategy when cash is on the sidelines and waiting to be put to work. For example, at times large institutional clients are transitioning between managers or doing a search for a new manager in a particular asset class.  Rather than risking underperformance through “cash drag” (deviation of returns from a benchmark’s returns due to cash holdings), the institution will invest in an ETF with similar asset class exposure as an interim solution.   

Institutions have been using ETFs for cash equitization since, well, the beginning.  In fact, when ETFs first came on the scene, they were mostly perceived as institutional products – and some of those institutions were getting their feet wet with the products by using them for cash equitization.  The largest and most liquid ETFs lend themselves to this practice because there’s now a wide variety to choose from, total costs are generally very low for short holding periods, and typically they’re easily traded throughout the day.

So why do institutions want to avoid cash drag, and how does their reasoning apply to individual investors?  Likely one of the biggest reasons an institution would choose equitization over holding cash is that they believe market returns will be positive over time (that’s why we invest, right?).  Both equities and bonds have experienced strong performance as of late (the S&P 500 Index was up 30% over the past year as of 6/30/2011).  Conversely, interest rates on many cash vehicles are near 0% at the moment, so portfolio cash may actually be earning negative real returns after inflation is taken into account.  And although cash holdings can reduce risk in the form of portfolio volatility, they can “drag” on returns in up markets.

In addition, the case for cash equitization can be even stronger in an institutional bond portfolio than in its equity counterpart.  For one thing, income from bond holdings naturally increases cash levels more than in an equity portfolio, making the portfolio more susceptible to cash drag.  And since a key component of a fixed income portfolio is often to invest in income-generating securities, the low yields on cash can work against that strategy.  When an institutional bond fund wishes to reduce its cash holdings and employ a cash equitization strategy, ETFs offer a compelling solution with an assortment of criteria to choose from such as yield, maturity, credit quality, and sector in order to match specific investment objectives and risk tolerance levels.

How does this apply to individual investors?  Well, they might have a certain amount in cash that they already know is eventually destined for the market, but that they just haven’t gotten around to investing yet (this is obviously much different than cash that’s been earmarked for savings or expenditures).  The “institutional approach” might be to consider using an ETF to get that cash off the sidelines and out of its zero- or near-zero-yielding account and into the market (if that’s where it’s headed eventually) to manage your own personal cash drag.  Keep in mind that investing in an ETF has much higher risks associated with it than investing in cash, so investors should consider their own risk tolerance and return objectives before entering the market.  Additionally, investors should work with their financial advisor and tax planner to determine if the costs of moving in and out of an ETF position and possible tax consequences outweigh the overall cash drag on their portfolio.

Past performance does not guarantee future results.

Buying and selling shares of ETFs will result in brokerage commissions.  There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Bonds and bond funds will decrease in value as interest rates rise.

Written By Kevin Feldman From The iShares Blog

Kevin Feldman, CFP® is a Managing Director in the iShares unit of BlackRock, the world’s largest asset manager. He has responsibility for iShares marketing, analytics and education. Mr. Feldman’s service with the firm dates back to 2007, including his years with Barclays Global Investors (BGI), which merged with BlackRock in 2009. At BGI, he was Director of Global Web Solutions, where he had responsibility for online education, portfolio analysis tools and global product data. Mr. Feldman earned a BA degree from the University of California, Los Angeles and an MPA degree from Harvard University.

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications or other transactions costs, which may significantly affect the economic consequences of a given strategy.

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