The Error-Proof Portfolio: For Near-Term Reserves, True Cash Isn't Trash

I made a few small tweaks to my sample bucket retirement portfolio last week. I swapped in a short-duration TIPS fund in place of the longer-duration fund that originally appeared in the portfolio, and I also adjusted the liquidity component of the portfolio. (Duration is a measure of interest-rate sensitivity.)

In the original version of the portfolio, I used two holdings for the liquidity bucket (bucket 1): true cash to supply the first year's worth of living expenses and an ultrashort bond exchange-traded fund,  PIMCO Enhanced Short Maturity ETF (MINT), for Year 2 reserves. My revised portfolio ditched the PIMCO fund and instead recommended that investors hold true cash--certificates of deposit, money market accounts and funds, and good old-fashioned checking and savings accounts--for near-term liquidity needs. 

My reasoning boiled down to two factors: yield and risk. You can easily obtain a two- or even one-year CD with a yield that beats the payouts of most ultrashort funds. Moreover, a CD is FDIC-insured (up to certain limits), whereas the ultrashort fund is not. Given that, cutting the ultrashort loose in favor of true cash was a layup. Indeed, ultrashort funds would seem to represent a very poor alternative to cash right now, owing to a few separate factors.

The Risk Is There . . .
From a risk standpoint, mutual funds like ultrashort and money market funds are at a disadvantage from the get-go relative to true cash vehicles such as CDs and bank-issued money market accounts. That's because mutual funds, even those focusing on high-quality bonds with very short maturities, as money market funds and ultrashort bond funds generally do, are not required to maintain stable net asset values and they're not FDIC-insured.

Money market mutual funds have maintained stable net asset values as a convention, but the Reserve Primary fund's well-publicized "breaking of the buck" during the financial crisis in the fall of 2008 demonstrated that not all firms have the wherewithal to make shareholders whole if the securities in their portfolios dropped in value. The FDIC subsequently instituted temporary guarantees on money market funds to stem a mass exodus from the funds in late 2008, and the SEC tightened the rules regarding maturities, credit quality, and liquidity of money market funds in 2010. The SEC has also debated additional reforms to money market mutual funds.

Yet even though the money market fund universe may be safer than ever, the ultrashort fund universe--where managers are allowed to own longer-maturity and lower-quality bonds than are allowable in the money market universe--doesn't even adhere to the convention of a stable net asset value. Indeed, some of the fund world's biggest blowups in recent years have occurred in this space. The now-defunct Schwab YieldPlus fund, for example, fell 35% in 2008 as risky bets on securities such as private-issuer mortgage-backed bonds fell in price.  Charles Schwab (SCHW) eventually shuttered the fund, paying handsomely to settle charges with the SEC and other regulators and to settle class-action lawsuits. Fidelity Ultra-Short Bond Fund didn't fall nearly as spectacularly, but its 5% loss in 2007 and 8% loss in 2008 no doubt caught many shareholders off guard.

. . . But the Extra Returns Aren't
Of course, most ultrashort funds aren't taking outsized risks that could lead to calamity but instead are taking only modest risks--venturing into only slightly lower-quality and/or longer-duration securities than money market vehicles can buy. And in some market environments, ultrashort funds can make up for those modest risks by offering higher yields relative to those of money market vehicles. During the past three-, five-, and 10-year periods, the average ultrashort fund has delivered a higher return than the typical taxable or municipal money market vehicle. Morningstar senior fund analyst Sarah Bush says because money market funds are so constrained in the types of securities they can buy, there can be opportunities for ultrashort fund managers, who have more flexibility, to pick up overlooked bonds. 

Yet Bush and Morningstar senior fund analyst Eric Jacobson agree that the yield curve--which depicts the yield pickup that one gets for venturing into longer-duration bonds--is unusually "flat" for shorter-maturity bonds, meaning bonds with maturities of less than two years. In a more normal environment, yields increase as one is willing to take on more interest-rate risk. But Jacobson reports that the yield differential between three-month and two-year securities is now just a measly 28 basis points, or 0.28%. He says that's because "market expectations, supported by the Fed, are that short policy rates will continue at their current near-zero levels for such a long time into the future.”

Ultrashort funds' unattractiveness relative to CDs is compounded by the fact that, as managed products, they have expense ratios that are subtracted from their yields. Even relatively inexpensive funds such as Fidelity Conservative Income Bond  and PIMCO Enhanced Short Maturity, with expense ratios of 0.40% and 0.35%, respectively, see a significant percentage of their yields gobbled up by costs. Most funds in the ultrashort group, which has a median expense ratio of 0.59%, have to clear an even higher hurdle than that. 

That's not to say ultrashort funds won't, at some point, be a viable alternative to true cash instruments, especially if bonds in their maturity ranges begin to offer higher yields relative to securities with very short maturities. But given ultrashort funds' additional risks and, in some cases, lower yields relative to guaranteed options, it's hard to make a case for them right now. 

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