The steady rise in interest rates over the last year or so has many investors and advisors reexamining a forgotten asset class. We’re talking about cold hard cash. With risk-free rates on cash still hovering above 4.5% and some cash-like products offering 5%+ yields, cash holdings have once again become part of the asset allocation equation. Today, trillions of dollars now sit in money-market and cash products.
The question is, is that the right approach? How much cash should we hold?
The answer may not be a one-size-fits-all solution — but there is a framework for deciding that allocation. And for some investors, too much cash may not be a good idea.
Rising Rates & Surging Cash Balances
The Federal Reserve’s rate hikes work in two ways to cool off the economy. First, they make borrowing more expensive. Loans become more costly for businesses and consumers, so spending decreases. The second effect is that saving becomes more advantageous. When the Fed raises rates, short-term yields spike. And this is what has happened today. With the Fed keeping rates higher for longer and pausing on potential cuts, saving has become very advantageous indeed.
Cash is again emerging as a real asset class.
Right now, yields on safe money-market funds, CDs, T-bills, and even savings accounts are paying rates not seen since before the Great Recession. Today, investors can score yields north of 4% on most cash products and even over 5% if they know where to look — that is a great risk-free rate of return. And investors have taken notice. According to investment researcher ICI, investors have plowed more than $19.3 trillion into bank deposits, money-market funds, and certificates of deposits. Money-market funds alone hold over $6.10 trillion in assets. 1
The reasons for holding that cash are varied. According to a new survey from cash-management solutions firm Flourish, the top three reasons investors hold cash are over concerns about a market downturn (65%), for emergency purposes (61%) and to fund an upcoming major purpose (56%). Other reasons include paying future tax liabilities (33%) and as a cushion over job uncertainty (18%). The survey allowed investors to choose more than one reason for their cash holdings. 2
The Role of Cash
Looking at the above reasons, it’s easy to see why investors choose cash for their portfolios. Moreover, the high interest rate environment makes choosing cash even more of a no-brainer — at least on the surface.
Cash and cash-like equivalents are some of the most liquid assets on the planet. You can easily spend from a savings account or write a check from a money-market fund. T-bills quickly turnover and can easily be sold on the secondary market. Even the penalties for closing a CD early aren’t that extreme. At the same time, cash is volatility-free and relatively stable in value. Even T-bills don’t bounce around or change too much in price.
Thanks to its liquidity factor and stability, it makes sense why cash is king for investor use.
But there is more to deciding cash holdings than just stability and interest rates. According to Vanguard, risk tolerance, time horizon, and funding level should all play into the cash allocation decision.
Risk tolerance is easy to understand. If the gyrations of the stock market keep you up at night, then holding more cash in a portfolio may make sense.
Time horizon is perhaps the biggest hurdle in determining cash allocation. Over the long haul, cash has historically underperformed rates of inflation by a wide margin. Investors need some additional spread/return over cash to keep ahead of inflation. This chart from Vanguard shows that over the last twenty years, cash has outperformed inflation in only four years.
Source: Vanguard
Part of that lower return has to do with the Fed and interest rates. Cash and similar assets are some of the first to realize cuts. While the central bank has paused and kept rates high, the potential for rates has grown. Those juicy 5% yields on cash may not last forever.
Funding level also plays into effect with regard to cash. A high-net-worth family or individual may already have all the money they need, and the return of principal is more important than the return on principal. Investors focused on saving for retirement or other life goals will likely not generate enough returns using high cash balances to meet future spending needs.
Cash Segmentation to the Rescue
Considering the reasons investors hold cash, along with potential risks and a new allocation framework, we can determine the appropriate amount of cash needed for our portfolios. The reality is, that most of us are probably holding too much cash in our portfolios. The Flourish survey shows that most advisors believe their clients only have about 14% of their liquid net worth in cash. However, the number is actually closer to 34%.
The answer to all the reasons and the potential framework questions could be cash segmentation in portfolios. Here, investors think about their cash needs in a few different buckets — daily needs, six months to one year, one to three years, etc.
With that, investors can potentially go out further on the yield curve, move out of direct cash, and into other short-term and limited duration bonds. Here, investors can get more returns and keep the hand of inflation at bay. Liquidity for these products and bonds is also pretty good.
The bottom line is that investors may be holding too much cash for their actual needs. Cash segmentation can provide a framework to meet liquidity, get slightly higher returns, and potentially beat inflation, all while maintaining safety.
Cash-Like & Short-Term Bond ETFs
These ETFs were selected based on their low-cost exposure to cash and cash-like bonds. They are sorted by their YTD total return, which ranges from 1% to 3%. They have expense ratios between 0.03% and 0.51% and assets under management between $590M and $58B. They are currently yielding between 3.4% and 5.7%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| MINT | PIMCO Enhanced Short Maturity Active ETF | $11B | 3% | 5.5% | 0.35% | ETF | Yes |
| PULS | PGIM Ultra Short Bond ETF | $6.29B | 3% | 5.7% | 0.15% | ETF | Yes |
| JPST | JPMorgan Ultra-Short Income ETF | $22.6B | 2.7% | 5.3% | 0.18% | ETF | Yes |
| ICSH | BlackRock Ultra Short-Term Bond ETF | $5.83B | 2.5% | 5.4% | 0.08% | ETF | Yes |
| SHV | iShares Short Treasury Bond ETF | $18B | 2.4% | 5.1% | 0.16% | ETF | No |
| ULST | SPDR SSGA Ultra Short Term Bond ETF | $591M | 2.3% | 5.2% | 0.20% | ETF | Yes |
| LDUR | PIMCO Enhanced Low Duration Active ETF | $902M | 1.8% | 4.8% | 0.51% | ETF | Yes |
| NEAR | BlackRock Short Duration Bond ETF | $2.96B | 1.5% | 4.9% | 0.25% | ETF | Yes |
| BSV | Vanguard Short-Term Bond Index Fund | $57.3B | 1% | 3.4% | 0.04% | ETF | No |
| SCHO | Schwab Short-Term U.S. Treasury ETF | $10.8B | 1% | 4.6% | 0.03% | ETF | No |
In the end, cash has become a valuable tool for portfolios, and investors are using it to protect their portfolios in very distinct ways. However, the time horizon plays a big role in how that cash performs. With that in mind, segmenting our cash makes sense to boost returns while still providing liquidity/safety.
Bottom Line
Thanks to high interest rates, cash has become an asset class contender once again. Using cash as a portfolio tool takes a keen understanding of how you plan to use that cash and when. By using this framework, you can segment your cash to potentially drive future returns and beat inflation.
1 Flourish (March 2024). Client Cash:Mapping an Underexplored Opportunity
2 ICI (June 2024). Money Market Fund Assets