Morningstar ETFInvestor editor Sam Lee explains what to do with it.
The following is based on a blog post originally sent out to subscribers of the ETFInvestor newsletter on May 26, 2013.
The most common question I get from subscribers is some form of "What should I do with excess cash?" The frequency and urgency of the queries make me think investors have run out of patience with low yields on their "safe" money. By "safe," I'm talking about money for a down payment on a house coming up in a few years, emergency funds, and the like. If that's the case, the answer is simple: Take your lumps. Everyone needs a ready source of cash to meet near-term obligations, some of which can be large and surprising. Nothing "cashlike" has the safety and liquidity of cash itself. A bad way to make up for miserly cash yields is to buy short-duration credit bonds and money-market alternatives, which still often yield less than 1%. It's easy to find FDIC-insured accounts that provide even better yields. The only reason to resort to the likes of Vanguard Short-Term Bond ETF BSV, iShares 1-3 Year Credit Bond ETF CSJ, Vanguard Short-Term Corporate Bond Index VCSH, PIMCO Enhanced Short Maturity Strategy MINT, etc., is if you're managing a portfolio so large it's not worth dealing with FDIC-insured accounts.
If your excess cash is truly excess, itching to go somewhere for a return, my answer is more complicated. The world is drowning in liquidity. Central banks have ratcheted real interest rates down, have helped lubricate the credit system by accepting lower-quality collateral, and in notable cases are buying assets outright. If you believe central banks will maintain low interest rates for a long, long time, then the rational response is to put your money in equities and accept lower expected returns. If you believe interest rates will rise faster than the market expects, then the only safe haven is cash and short-selling duration in all its forms.
Broadly speaking, there are three options for your cash:
1) Stay in cash and hope to exercise its implicit call option sometime in the future. (The true value of cash is its ability to buy assets on the cheap during bad times. Most investors don't have the nerve and patience to do this.)
2) Invest in "betas," or traditional asset classes. However, almost everything is fairly expensive. A notable exception is emerging-markets equities, which look fairly priced. GMO recently released its seven-year asset-class return forecasts showing emerging-markets equities as the highest-expected-return opportunity today, a belief I share.
3) Invest in "alphas," or excess returns arising from skill-based strategies. In theory, the supply of alpha doesn't depend on market valuations. Skilled investors can outperform by taking advantage of relative mispricings.
The first choice is a siren call that has sunk many a portfolio. Investors who have sat on cash for the past four years waiting for a pullback have shot themselves in the foot, to put it mildly. However, I think a moderate holding of cash is a reasonable choice right now given high valuations and the heightened possibility of something terrible and unexpected occurring. I've been keeping about 10% of the ETFInvestor model portfolios in cash for these reasons and, unlike many of my subscribers, I am considering raising even more cash.