Recent
commentary about “cash drag” in a diversified investment portfolio blurs the facts through omissions and faulty comparisons.
Every asset class serves a purpose. Equities offer growth potential, bonds and dividend-oriented stocks provide income, real estate investment trusts (REITs) and Treasury inflation protected securities (TIPS) offer inflation protection. Modern portfolio theory argues that cash and cash alternatives also serve strategic purposes in a portfolio, providing stability, downside protection, and growth through reinvested interest.
The most accurate way to analyze the impact of cash on a portfolio is to examine both the risk side and the return side, and specifically to view cash relative to other alternative conservative investments for that component of the portfolio.
The risk arguments in favor of cash have to do with its unique characteristics as a defensive asset and we discuss them at length in
a whitepaper on the role of cash in automated portfolios, including:
• Cash is the most consistently reliable of the defensive asset classes. Other conservative asset classes can and do lose face value in certain market environments.
• Cash has the most consistently low correlation with other asset classes.
• Cash is a form of insurance that supports a portfolio during down or choppy markets, which occur more frequently than people appreciate.
• Cash plays a behavioral utility in portfolio construction to address the loss aversion inclination of individual investors.
Just as important to consider is the improved impact that cash has on a portfolio's return relative to the cash alternatives used in other automated investment programs. In that regard there are two factors to consider: the return profile of cash alternatives, and the impact of platform service fees on those returns.
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The truth about cash and cash alternatives
In assessing how cash investments might affect expected returns, some have simply assumed that a cash allocation would earn the return of the rest of the portfolio if it were not held in cash. But redistributing the cash allocation proportionally across the other assets in the portfolio would alter the investor's risk profile and ignores the actual intended composition of the portfolio, making the comparison meaningless. A portfolio that is fully invested in equities might have a high long-term potential return, but that return would come with more volatility than most investors could withstand and, depending on their time frame, would insert significant risk.
A more accurate analysis would make an apples-to-apples portfolio comparison that assesses other cash alternative investments, such as short-term Treasuries, that are being used in the portfolio to provide the ballast that cash can deliver, and would consider how using one of these cash substitutes in place of cash would affect the portfolio's expected returns.
Don't ignore how automated investment service fees create a drag on returns
An important factor that affects the performance of cash alternatives is their expense. Costs matter. Fees add up over time and create a drag on investing performance. Fees are an important component of any investment model when paying for important benefits, like customization, wealth management insight, or portfolio assessment. But if given a choice between an additional layer of fees for automated investment services without additional benefit, or not bearing the burden of those fees, avoiding those fees is a better way to go.
Invested cash – as is used in Schwab's Intelligent Portfolios – does not include a management fee; it simply earns interest in the portfolio. By contrast, an exchange-traded fund (ETF) that invests in a cash substitute such as short-term Treasuries will have an operating expense ratio (OER). And when an automated investing fee is included on top of that, our analysis finds that the portfolio with the pure cash allocation would be superior in nearly all scenarios.
(More insight: Schwab Intelligent Portfolios bets big on cash and 'smart' beta)
What is the impact on expected returns if ultra-short Treasuries are used instead?
The following analysis assumes two identical portfolios, one with a cash allocation and a second that replaces the cash with an ultra-short Treasury ETF. Ultra-short Treasuries typically have durations or effective maturities of less than one year.
The OER for a typical ultra-short Treasury ETF is about 0.15% while cash has no OER. However, ultra-short Treasuries would be expected to earn a higher return than cash. Based on the capital market expectations of Charles Schwab Investment Advisory, Inc. (CSIA), the expected return spread of ultra-short Treasuries over cash is 0.19% on an annualized basis. The expected return spread does exceed the ETF management costs, just barely. However, if we layer on a typical advisory fee of 0.25% that applies to the entire portfolio, then the alternate portfolio can have a lower expected return, depending on the amount of cash in the portfolio.
Table 1 (below) shows what would happen to the expected return of a conservative, moderately conservative, and aggressive portfolio within Schwab Intelligent Portfolios based on the level of their cash allocations if we used an ultra-short Treasury ETF instead of cash and applied an auto investing advisory fee.
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This shows that the alternate portfolio using ultra-short Treasuries actually would have a lower return than the portfolio with cash, by about 0.25%. The return spread of the ultra-short ETF is higher than the OER of the ETF, which benefits the alternate portfolios, but that impact is more than offset by the advisory fee that's applied to the entire portfolio.
What is the impact on expected returns if short-term Treasuries are used instead?
Ultra-short Treasuries are not the only potential cash substitute. Some might instead use a short-term Treasury ETF, which typically focus on Treasuries with a maturity between one and three years. Table 2 (below) shows what would happen to the expected return of Schwab Intelligent Portfolios if we used a short-term Treasury ETF instead of cash and applied an advisory fee.
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Again, the alternate portfolios have lower expected returns in all three cases, but note that the return gap is smaller than it was when an ultra-short ETF was used as the cash substitute. That's because short-term Treasuries have a higher expected return than ultra-short Treasuries, as well as higher risk. In fact, between 1990 and 2014, ultra-short Treasuries experienced 32 months with negative returns, a little more than 10% of months during the period. And short-term Treasuries experienced 61 negative months, or 20% of months during the period. By contrast, cash experienced no months of negative returns during the period.
Cash allocation serves an important purpose in a portfolio
Schwab Intelligent Portfolios includes cash as part of a broadly diversified portfolio that also includes up to 20 asset classes across equities, fixed income, and commodities. We believe that cash serves an important purpose in asset allocation, providing a source of stability, downside protection and diversification. Along with the important property of risk reduction that cash provides, our analysis shows that a cash allocation provides a superior expected return relative to cash alternatives when the true costs of those alternatives are considered and does not result in a drag on portfolio returns. The real “drag” is paying too much in automated investing advisory fees.
David Koenig is vice president of Schwab Wealth Investment Advisory, Inc.
