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.
The second choice is really an implicit bet on low interest rates continuing. Everything is priced in relation to prevailing interest rates. If they unexpectedly go up, all things held equal, the prices of all assets with cash flows will fall. Because rates are so low, small increases will hurt asset prices more than an equivalent rise during more normal times. Of the betas, emerging-markets equities are among the cheapest. They yield about 3% and have the potential to grow their dividends at a decent clip.
The final option, investing in alpha, is a mug's game for most. Some mistakenly believe that they can supplement low expected returns with more skill-based returns, either by investing more in actively managed funds or by taking greater control of their portfolios. The markets aren't going to be any easier to beat just because you desperately need to make up for lower yields. Whether valuations are high or low shouldn't affect your decision to invest in alphas. If you have an edge, you should be exercising it as aggressively as possible, regardless of the expected returns of betas. If you don't, then you should avoid alpha bets.
My best idea isn't even related to ETFs. I think you should look into taking out a 30-year fixed-rate mortgage and buying property (at a reasonable price, of course). Warren Buffett says the dumbest investment right now is the long-term government bond. If that's the case, then the smartest investment is shorting it--borrowing lots of money at a fixed-rate for a long time. I first urged subscribers buy a house back in December, assuming the need and ability to do so without overextending one's balance sheet. My advice still stands.
A 30-year fixed-rate mortgage has several appealing qualities. First, after expected inflation and the mortgage-interest tax subsidy, the expected real interest rate on the loan is close to zero and may even be negative. Second, it's a natural inflation hedge and to a lesser extent a hedge against rising real interest rates. Third, it's not callable. There's no need to stump up a ton of cash at a moment's notice (usually the worst time possible) to satisfy a lender's margin calls. In this respect, it's a lot safer than traditional forms of leverage, because you can ride out mark-to-market losses without having to liquidate assets at fire sale prices.
If you already have a mortgage, take your sweet time paying it off. If you have young-adult children with decent credit and stable jobs, and you intend to leave a bequest, help them with a home down payment instead. And whatever you do, please don't extend Uncle Sam too many fixed-rate loans.
Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.