Indecisive? Too Much Cash? Use ETFs

Exchange-traded funds and products are useful when investors have too much cash on the table

Jose Garcia Zarate 22 February, 2012 | 11:05AM
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One of the main tactical uses for exchange-traded products (ETPs) is that of cash equitisation. This is a short-term investment strategy that is normally rolled out in times of transition. Investors can use ETPs in the short-term while refining a longer-term investment view. For example, when an investor takes time to rethink their long-term goals, instead of holding excess cash, they could buy a broad-based, liquid ETP to continue tracking market returns. The aim of cash equitisation is to eliminate the negative effects of the so-called “cash drag”. Cash drag is the opportunity cost of maintaining near-risk-free readily accessible but generally very low-yielding cash holdings as opposed to investing in comparatively higher-risk higher-yielding asset classes.

Anecdotal evidence suggests that institutional investors have been using ETPs for cash equitisation purposes almost since they first came to the marketplace. But this is not just a strategy for professionals. Cash equitisation using ETPs offer a relatively easy way for individual investors to also engage and benefit from this tactical investment use.

Keeping Cash
It is important to understand that maintaining cash positions in an investment portfolio is not a negative thing in itself. In fact, cash can be part of an optimal asset allocation as it affords investors a considerable degree of flexibility in their investment-decision process. The problem arises when the level of cash holdings becomes excessive relative to the investor’s desired asset allocation mix. This clearly implies that excessive cash holdings are the direct product of investor’s indecision and not the result of a targeted increase in cash positions fitting a “cash preservation” investment strategy. This is where cash equitisation using ETPs comes in handy.

As a means of a practical example, the net inflows experienced by European money market ETPs for most of H2-2011 – in effect a net increase in cash positions – cannot be rationalised as anything other than a conscious decision by investors to protect cash against the backdrop of highly volatile investment conditions, both in equity and fixed income markets. In circumstances like these, cash drag is not a hindrance but a willingly accepted trade-off. In short, cash drag only becomes a problem when the investor would ideally be invested in assets other than cash. For instance, an investor would ideally be invested in the UK equity market but cannot make up his/her mind as to which specific sector. In these circumstances, the investor may be better off temporarily buying the broad market while a final investment decision is made. Assuming the market performs positively during the interim, the investor would be able to capture broad market returns, thus reducing or fully eliminating cash drag.

Why Use ETPs?
The generally short-term nature of the cash-equitisation strategy calls for liquid vehicles that can be quickly and cheaply transitioned once an investment decision is made. Before the irruption of ETPs, cash equitisation was traditionally carried out setting up long positions on futures contracts and/or buying call options on a given market index. However, the mere mention of the terms “futures” and “options” implies that cash equitisation, albeit a simple concept, is likely to have proven fairly difficult to execute for investors – mostly individual – lacking the know-how to operate with these financial instruments. Of course, one may argue that traditional mutual funds were also a valid option for cash equitisation, but a) they generally lack the flexibility of real-time traded futures and options and b) running costs – and possible redemption in case of early exit – could outweigh the benefits of eliminating cash drag.

Investors can now use simple-to-operate, low-cost ETPs to meet their cash equitisation needs. ETPs have the real-time trading flexibility of futures and options, while doing away with inconveniences such as having to roll contracts at specific periods or – in the case of futures – being constrained to a handful of market indices. ETPs also have the advantage of lower running costs vis-a-vis traditional mutual funds, although investors should carefully account for ETP trading costs (e.g. too frequent trading can result in mounting costs that could offset the benefits of cash equitisation).

ETPs are sometimes described as “democratising” instruments for their role as facilitators of exposure to all kinds of asset classes. But their “democratising” qualities can also be understood as facilitators of investment practices as well. While institutional investors were the first to use ETPs for cash equitisation, now retail investors can also engage and benefit from this strategy.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Jose Garcia Zarate

Jose Garcia Zarate  is Associate Director of Passive Strategies Research for Morningstar Europe