What To Do With Your Cash Right Now

Ruth Saldanha: Netflix’s no-password-sharing has boosted the company’s revenue—but the stock is still expensive. How can bond managers compete with 5% yields on cash? What should—and should not—be in your core portfolio? This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ruth Saldanha. Let’s get started with a look at your Morningstar headlines.

Netflix Surpassed Expectations

Netflix released a solid earnings report for the second quarter, topping Morningstar estimates. The streamer’s crackdown to turn password sharing into paid sharing led to the addition of almost 6 million subscribers. Netflix now boasts that it has more than 238 million global paid subscribers. Management says it expects growth to continue as the paid sharing plan is rolled out in all its markets. Despite the additional subscribers and fees, revenue lined up with estimates, partly due to stagnant average revenue per user in North America and Europe, Netflix’s two largest regions. Revenue rose 3% to $8.2 billion. However, growth hasn’t hit double digits since the fourth quarter of 2021, despite price hikes and the crackdown on password sharing. And once the benefits of paid sharing level off, attracting new subscribers will likely be challenging, even as competition in streaming is intensifying. Morningstar is upping its estimate for what Netflix shares are worth to $330 from $315. But still, the stock appears overvalued.

United Airlines Q2 Results Soared

United Airlines reported robust second-quarter results, but higher costs loom on the horizon. The airline’s passenger revenue surpassed Morningstar’s expectations, and it almost sold out capacity, or available seats. Pilot hiring and delayed delivery of Boeing planes have constrained the U.S. airline industry. A shortage of air traffic controllers has led to capacity cutbacks. The playing field should remain level in the competitive industry as long as this continues. Morningstar expects higher revenue and booking rates across the board. Costs are starting to go up, however, as airlines try to push capacity beyond 2019 levels. Low fuel prices and unusually full planes should pay for these increases. Once either of these wavers, though, Morningstar expects lower profitability and the return of risky price competition. Morningstar is lowering its estimate for what United’s shares are worth by $1, to $35 per share.

PNC Projected Slower Growth

PNC Financial Services reported slightly weaker results than the biggest banks. The regional bank also projected slower growth in net interest income, or the money that banks make on loans for the full year, while larger lenders actually raised their outlooks. Rising funding costs like higher payouts to savers on their deposits and slower loan growth are driving the decline. Despite the down numbers, results came in close to Morningstar’s expectations. Morningstar says regional banks will face more pressure on net interest income than the largest banks. That’s in line with updated expectations, and it isn’t leading to dramatic negative revisions like in the last quarter. PNC’s revenue and net interest income are still set to grow this year, despite this year’s banking crisis. Morningstar plans to update its forecast and may lower its $175 estimate for PNC shares. Currently, the stock looks undervalued.

Inflation, Cash, and Bonds

No one has escaped the effects of higher inflation—whether it’s when we are paying more for gas or groceries or utilities. To tame these prices, the Fed has been raising rates, and as a result, cash rates have skyrocketed—in some cases to as high as 5%. How can bond managers compete? Madeline Hume is a NEXT senior research analyst for Morningstar Research Services, and she has been tracking this space and is here to talk about it. Madeline, thank you so much for being here today.

Madeline Hume: Thank you for having me, Ruth.

Bond Outlook 2023

Saldanha: What do flows look like for bonds, especially short- and medium-term bonds?

Hume: Overall, flows are pretty steady when you look at bond funds in general, but that belies a lot of volatility underneath. You’ve got a large reallocation happening away from short-term bonds into bond funds that invest in longer-term bonds and also into cash. The category has lost a staggering $19 billion year to date, ranking among the highest in bond categories for outflows.

Why Should Investors Consider Bonds?

Saldanha: Is fleeing for bonds in favor of cash a good strategy right now? With yields being so high, why should investors consider bonds at all?

Hume: Yeah, it’s not a good idea now, and it’s not a good idea ever. Cash and bonds both have yields, but ultimately, they serve different purposes in an investor’s portfolio. Bonds have something that’s known as duration, which basically means rate sensitivity. Cash doesn’t have that. So effectively, you’re comparing apples to oranges.

Opportunity Costs of Holding Money in Bond Funds

Saldanha: What about the opportunity cost of holding money in tied-up bond funds?

Hume: The flip side of cash rates right now is, with cash, what you’ve got is a yield that looks really promising and is quoted on an annual rate, but that rate can change at any time if interest rates are adjusting. When you think about asset allocation and diversification, it’s a bit like a Ferris wheel. If something is up, that means that one asset class is performing well and another asset class is down, but that can change very quickly. So as I mentioned, with cash rates in particular, that can change nearly instantly.

Bond funds, meanwhile, have money that’s locked up for a little bit longer, and so you have a guaranteed rate that holds for a little bit longer period of time. There are benefits and there are drawbacks to that. The drawback is that your money is locked up, and so there may be a more promising rate elsewhere, but you have to remember that, with investing, the grass is always a little bit greener somewhere else.

The reason that bond funds are not earning as much as cash right now is because yield curves are inverted, and that means that investors don’t know as much about the short term as they do about the long term, so they command a little bit higher premium in order to keep their money in shorter-term investments because they’re not sure if in six months or in 12 months the Fed is going to be lowering those interest rates.

That’s not the normal state of affairs. For investors, while they may be buying bonds now and those rates may be lower than what cash is, eventually rates will normalize and longer-term rates will come back up, and so there is this mean-reversion effect that you’ve got going on. So for people who choose to put their money in cash, if rates fall, their yields immediately adjust, but bonds allow investors to reduce their reinvestment risk, and they don’t have to necessarily worry about that scenario.

Income in Investor’s Portfolio

Saldanha: What should investors do for the income portion of their portfolios right now?

Hume: Cash yields are so tempting right now that it’s easy to forget that we’ve entered in an entirely new paradigm as far as interest rates go. Two years ago, a bond yielded about 0.21%, and today a two-year bond is yielding about 4.9%. So while you might be able to make marginally more money in cash, ultimately 4.9% is still nothing to sniff at. It’s certainly much better than the scraps bond investors have been feeding on for the past 10 years. If you’ve got the right asset allocation, ultimately the best advice that I have is to do nothing and let the markets do their thing.

Saldanha: Great. Thank you for joining us with your perspectives, Madeline.

Hume: Thank you so much, Ruth.

5 Surprising Investments That Shouldn’t Be Long-Term Core Holdings

Saldanha: Most of us construct our portfolios around some core holdings, and then there may be some fun or play holdings. New Morningstar research shed some light on the types of funds that should be in the core holdings for most investors’ long-term portfolios—and some that absolutely don’t belong in that coveted core holding spot. Amy Arnott is a portfolio strategist for Morningstar Research Services, and she sat down with Morningstar Inc.’s investment strategist Susan Dziubinski to discuss this. Let’s listen to what they had to say.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. New Morningstar research shed some light on the types of funds that should be the core holdings for most investors’ long-term portfolios. But what types of funds don’t belong among an investor’s core holdings? Let’s find out. I’m joined today by Amy Arnott, who is a portfolio strategist with Morningstar Research Services.

Hi, Amy. Nice to see you today.

Amy Arnott: Thanks, Susan. Nice to be here again.

Dziubinski: Now, we’ve talked before about your role in portfolio research, and viewers who are interested in learning more about that can watch the video through a link that will be included in the transcript. But give us a quick rundown of what the research is about and how investors can use it.

Arnott: Sure. This role in portfolio framework is really designed to give investors practical guidance when they’re trying to put funds together in a portfolio. It’s not just about finding good funds with low expense ratios, but then taking the next step of how do you put them together in a portfolio in a way that makes sense for your specific financial goals. When we came up with this, there are two key dimensions: One is the time horizon, and the second one, as you mentioned, is the role in portfolio—or what size should a position play within the portfolio.

Dziubinski: Amy, in your research, you define four roles in portfolio that an investment can offer based on the diversification that it provides. And those four roles are stand-alone, core, building block, and limited. Now stand-alone funds are those one-and-done investments that are going to provide you diversification in one place, maybe a target-date fund or asset-allocation funds. Core funds are the funds that should take up the bulk of a portfolio for an investor who doesn’t want to necessarily pursue that stand-alone approach to their portfolio, that one-and-done approach. The Morningstar Categories that qualified in your research as core holdings would be from the U.S. large-blend, the foreign large-blend, and the global large-blend categories. Why these three categories?

Arnott: As you mentioned, we look at core holdings as something that would be appropriate for a large percentage of your assets, which we define as somewhere as much as 40% to 80% of your assets. And we look at core holdings as something that’s going to give you broad representation for a major asset class. In the case of the three categories that you mentioned, we’re looking for broad exposure to stocks in general. And the three categories that you mentioned we think are appropriate as core holdings on the stock side because they are really giving you a broad representation of the overall stock market. If you look at something like Vanguard Total Stock Market, VTI, for example, you’re getting exposure not just to that middle section of actual large-blend stocks but also some exposure to large-growth and large-value. So, if you’re looking for something that’s going to represent the equity market in general, a fund like that or a similar fund from the foreign large-blend or global large-blend category is a good place to start.

Dziubinski: Got it. So, you mentioned U.S. large value and U.S. large growth, and it may surprise some readers—it surprised me a little bit—that these types of funds, these fund categories don’t actually fall under the definition of how you’re defining the core fund camp. Instead, they’re sort of the next tier down. They’re part of that building-block type of holding in a portfolio. Walk us through why they aren’t core.

Arnott: If you look at large value or large growth, these are smaller slices of the equity market, so it’s not giving you quite the same level of broad market exposure. Another issue is that just as we found that it’s very difficult for active managers to outperform by deviating from a market index, it’s also very difficult to outperform by overweighting a specific investment style. If you do that, there might be periods when you have good returns. For example, on the large-growth side, that style outperformed by a pretty wide margin over most of the period from 2009 through 2021. But there have been other times when that would have really hurt your results. For example, during the technology correction that started in the year 2000, large-growth stocks fell behind by a pretty wide margin. And it would have taken you a long time, actually more than 13 years, to make up that loss. So, there’s definitely more risk associated with overweighting either value or growth.

Dziubinski: Got it. So, now, another surprise for some investors might be that U.S. small-cap blend, small-cap value, and small-cap growth, those categories aren’t considered core in your framework. And in fact, they’re not even considered building blocks. They were assigned the limited role, which is even further down the ladder. Why is that?

Arnott: It all goes back to the idea of using the neutral market portfolio as a starting point for your equity investments. And typically, you want to keep your allocations in line with how the overall market is allocated. And so, if you look at the U.S. equity market, actually less than 10% of the outstanding market cap is in those small styles: small value, small blend, and small growth. So, that’s why we assign those limited roles.

Dziubinski: Got it. From a practical perspective, Amy, if investors, say, combine a U.S. large-cap growth fund with a U.S. large-cap value fund, have they really just assembled the equivalent of a U.S. large-cap blend fund? And then, in that case, if that’s what an investor is doing, could that really, those two funds combined, serve as the core of a portfolio?

Arnott: You certainly could do it that way. Starting out with equal weightings between large value and large growth, you would just have to make sure that you’re keeping an eye on those allocations over time so that they’re not getting out of balance. And you probably want to be rebalancing them once a year at least, or anytime the allocations get significantly out of balance.

Dziubinski: Amy, thank you so much for your time today. This role in portfolio research is really wonderful, and we look forward to talking with you more about it.

Arnott: Thanks. Great to be here.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Saldanha: Thank you, Amy and Christine! That’s all for this week’s episode. Don’t forget to subscribe to Morningstar’s YouTube channel to see new videos about market news, personal finance, and investment picks. Thanks to podcast producer Daryl Lannert, who put this show together. I’m Ruth Saldanha, an editorial manager at Morningstar. Thank you for tuning into Investing Insights.

Read about topics from this episode.

Netflix Earnings: Solid Results as Paid Sharing Boosts Subscriber Growth

United Airlines Earnings: Robust Q2, but Costs Rising on Upgrades and New Labor Agreements

PNC Earnings: Funding Pressure Remains, but Smaller Changes to Outlook\

Is It Time to Break Up With the Bonds in Your Portfolio?

What Role Should Cash Play in Your Portfolio?