- Cash investments play an important role within a well-diversified investment portfolio and serve several purposes, including greater stability, diversification and potential inflation protection.
- Schwab Intelligent Portfolios™ includes cash as an investment to help provide a stable foundation within an overall asset allocation that includes other asset classes such as equities, bonds and commodities. Cash allocations are determined according to an investor’s risk profile, with the most risk-averse or short-term portfolios holding the highest levels of cash and the least risk-averse or longer-term ones holding the lowest levels of cash.
- A meaningful cash allocation provides stability to help mitigate downside risk. Lower portfolio risk can help moderate downturns and keep investors focused on their longer-term goals rather than overreacting to short-term market movement.
- Cash investments in Schwab Intelligent Portfolios provide an additional layer of stability in the form of FDIC insurance of up to $250,000 per depositor as they are "swept" into deposit accounts at Schwab Bank, where they also earn a market rate of interest for highly liquid cash investments.
- Cash held in interest-bearing deposit accounts can also provide favorable return characteristics within a diversified portfolio relative to cash substitutes when the management cost of those substitutes and advisory fees are considered.
When it comes to cash investments, two commonly quoted idioms offer two widely divergent viewpoints. According to the first, "cash is king." In an investing context, this means that cash holdings may provide stability and readily available funds. According to the second, "cash is trash." Those with this opinion view cash as a poor investment because its yield is currently exceptionally low as a result of Federal Reserve monetary policy that has kept interest rates at low levels in recent years.
So, for the average investor, which is it? Is cash king? Or is cash trash?
As with most things in life, the truth lies somewhere between these two extremes. While cash investments don't currently provide the same level of income potential they have historically, the long-term data about cash and its value to investors suggests that cash remains an important investment within a diversified portfolio. An allocation to cash can provide:
- Stability and a solid foundation for the portfolio.
- Diversification benefits relative to other asset classes.
- Protection against potential future increases in inflation.
- Potentially favorable return characteristics relative to cash substitutes in the form of ETFs that come with operating expense ratios (management costs) and advisory fees.
For these important reasons, Schwab Intelligent Portfolios includes allocations to cash. The size of the cash allocation varies according to an investor's risk profile, with the least risky or short-term portfolios holding the largest levels of cash and the riskier or longer-term portfolios holding the smallest, though still meaningful, cash levels. This paper outlines our views about the purposes that cash serves within a well-diversified investment portfolio.
Schwab Intelligent Portfolios offers a range of portfolios to suit varying investor goals, financial situations, and preferences. The concepts of asset allocation and diversification that are the foundation of the portfolios are based on Modern Portfolio Theory, which states that optimal portfolios can be created by considering the relationship between risk and return. Additionally, research into the behavioral tendencies of investors based on their attitude to risk and reaction to potential portfolio volatility is taken into account.
An Investor Profile Questionnaire takes into consideration both objective (factual) and subjective (behavioral) information provided by an investor. The questionnaire assesses an investor's capacity to take risk as well as their willingness to take risk based on their attitude toward it. Assessing both of these aspects of risk tolerance gives greater insight into an investor's ability to absorb losses in their portfolio as well as their potential emotional and behavioral response to losses.
An investor receives a recommended portfolio based on their individual risk profile, which is established from their answers to the questionnaire. This risk profile helps determine the amount of cash—as well as the amount of other asset classes such as stocks, bonds and commodities—the investor is directed toward in the recommended portfolio.
How is cash invested in Schwab Intelligent Portfolios?
The cash allocation in Schwab Intelligent Portfolios is invested in the Schwab Intelligent Portfolios Savings Sweep Program, which is sponsored by Charles Schwab & Co., Inc.1 By enrolling in Schwab Intelligent Portfolios, clients consent to having the free credit balances in their portfolios swept to deposit accounts at Charles Schwab Bank. These deposit accounts will earn a market rate of interest for highly liquid cash investments that will be determined by reference to an index. Currently, that index is the national average of money market deposit account rates as calculated by RateWatch.2
What role does cash play in a portfolio?
Cash investments help provide liquidity and lower the volatility of a portfolio. When investment markets (e.g., equities and bonds) become volatile, the volatility of the portfolio as a whole is tempered because the value of the original cash investment stays relatively steady. That stability relative to other holdings whose prices are more volatile is what gives cash its diversification properties. Within Schwab Intelligent Portfolios, cash also provides an additional layer of safety as it is swept into deposit accounts at Schwab Bank, which are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor.3
When does cash perform well?
Two environments where cash tends to do well relative to other asset classes are periods of rising interest rates and times of stock market turbulence. In periods of rising interest rates, cash has done well historically relative to other asset classes because its duration is so short. Duration measures how sensitive a security is to changes in interest rates, or how much its price is expected to fall when interest rates rise and vice versa. Securities with shorter durations are generally less sensitive to changes in interest rates than securities with longer durations.
Cash is also a member of the "defensive asset" club, which includes assets such as ultrashort bonds, US Treasury bonds, international bonds and gold. Defensive asset classes tend to perform well during periods of stock market turbulence, and their price movements generally have relatively low or negative correlations with equity securities. What makes cash unique among other defensive assets is that it has the lowest price volatility of the group. By contrast, some other defensive assets (e.g., gold) have a great deal of price volatility associated with them.
When does cash perform poorly?
Cash may underperform in a very low interest rate environment where the central bank is keeping short-term interest rates low to stimulate economic growth, such as in the aftermath of the financial crisis in the United States. Since cash is very liquid, the rate paid to investors is generally low compared with the yield on other securities.
Although cash does not currently provide the level of yield that it has historically, the Federal Reserve began raising short-term interest rates in 2015. As interest rates increase over time, cash investments would be expected to see an increase in yield, as they have historically in rising rate environments. In the future, cash investments could again be a source of potential income in addition to providing safety and stability within a portfolio.
One of the first goals of investing is to protect principal and avoid permanent impairment of capital. In other words, avoid losses. Another important goal, of course, is to grow wealth. A meaningful cash allocation can help with both of these goals, providing a solid foundation for a portfolio and allowing for allocations to other riskier asset classes such as stocks that focus on potential growth over time.
Cash gains in importance as the length of time before the investor needs to begin withdrawing funds from the portfolio shortens. For investors at or nearing retirement, larger cash allocations can provide some necessary stability, as these investors have less time to make up for significant losses in the event of a sizable market downturn. For investors who need access to the funds in their account in just a few years for education needs or a down payment on a home, cash can provide the stability and liquidity necessary to ensure funds are readily available when needed.
A solid foundation that provides stability is also important for most investors regardless of their age because research into the behavioral tendencies of investors has shown that investors often have an emotional definition of risk. For example, investors tend to strongly prefer avoiding losses to acquiring gains, a phenomenon known as loss aversion. In fact, studies suggest that the psychological pain investors feel from a loss is twice as strong as the joy they receive from a similar size gain.4
Cash investments can help moderate downside risk
One of the reasons for holding a cash allocation is the stability it provides in helping to mitigate downside risk. Portfolios with lower risk generally don't decline as much in a market downturn, so they don't need to make up as much lost ground to return to breakeven compared to a portfolio that declined dramatically. For example, as shown in Exhibit 1, a portfolio that falls in value by 30% must grow by 43% to recover from its loss; a portfolio that declines by 10% only needs to grow by 11% to recover. Higher balances in cash investments can help provide downside protection and temper portfolio losses in the event of market declines.
Exhibit 1: Larger downturns require increasingly bigger subsequent gains to break even
|Beginning portfolio value||Portfolio loss||Portfolio value after loss||Required positive return to break even|
Source: Charles Schwab Investment Advisory, Inc. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product.
A more stable portfolio can help investors to weather market downturns
A cash allocation that helps to moderate market downturns can also help keep investors focused on their longer-term goals rather than overreacting to short-term market movements. This stable foundation can help give investors the discipline necessary to stay invested through the inevitable periods of market turbulence and better positioned to benefit when markets recover. Tempering the temptation to sell in a panic is one of the most important disciplines for successful long-term investing.
While cash investments might moderate overall portfolio returns when equity markets are advancing strongly, markets tend to go through periods of volatility. The potential long-term dampening of portfolio performance as a result of holding cash, sometimes known as "cash drag," assumes that investors remain fully invested over the period studied. However, behavioral tendencies often lead investors to sell investments after large market declines and be slow to reinvest after markets have bottomed. The early periods of market recoveries often deliver the strongest performance, and missing out on these periods can negatively affect long-term performance over time.5 For example, Morningstar has found that ill-timed decisions caused the average mutual fund investor to underperform the average mutual fund by approximately 2.5% annually over the 10-year period ended December 31, 2013.6
The case for including stocks in a portfolio for long-term growth is well understood by most investors. However, the reason for diversification is that an all-equity portfolio has historically experienced periods of high volatility. Sometimes less well understood is the amount of time historically in which a portfolio that included a blend of equities and cash performed as well as or better than the all-equity portfolio. In looking at five-year rolling periods between February 1970 and December 2015, a hypothetical portfolio that consisted of 90% stocks and 10% cash would have delivered a total return as good as or better than an all-equity portfolio 165 out of 492 periods, or 34% of the time. And notably, the blended portfolio achieved this with lower volatility than the all-equity portfolio 100% of the time.
Cash investments are less volatile than other defensive assets
In constructing broadly diversified portfolios, investors often include allocations to so-called defensive asset classes for stability and diversification. As stated earlier, defensive assets are generally assets that have low or negative correlations with equity securities. These asset classes tend to perform well when there is downward pressure on equities.
Examples of defensive assets include ultrashort bonds, Treasury securities, gold, international developed bonds, and cash. While each of these investments has defensive characteristics, cash provides the most stability, as illustrated in Exhibit 2.
- Ultrashort bonds can include a wide range of securities such as corporate debt, government securities, mortgage-backed securities, and other asset-backed securities typically with maturities of a year or less. The short duration of ultrashort bonds means that they have less interest rate sensitivity than bonds with longer maturities. However, ultrashort bonds are not FDIC-insured and do carry credit risk associated with the issuer. As shown in the chart, these risks caused ultrashort bonds to deliver higher volatility than cash and negative monthly returns approximately 12% of the time over the period from 1990 – 2015. That compares with no negative nominal monthly returns for cash investments.
- US Treasury bonds are also considered defensive because of their low correlation with stocks and because they are backed by the full faith and credit of the US government. While Treasury bonds don't have the credit risk characteristic of corporate bonds, they do have interest rate risk because of their longer maturities of up to 30 years. As a result of this interest-rate sensitivity, Treasury bonds have historically been significantly more volatile than cash investments and delivered negative returns approximately 34% of the time over the period examined. With interest rates currently at historical lows, rates are expected to increase in coming years, potentially pressuring Treasury bond prices.
- International bonds also tend to have relatively low correlations with stocks and an additional benefit of international diversification. But they have historically been nearly twice as volatile as Treasuries and more than 12 times more volatile than cash, with negative monthly returns more than 40% of the time.
- Gold is often considered the ultimate store of value, because of its limited supply relative to paper currencies that can lose value if governments ramp up printing. However, gold doesn't pay dividends like stocks or interest like bonds, and its volatility historically has been more than 20 times that of cash. Additionally, gold delivered negative monthly returns approximately 47% of the time, with a decline of more than 17% in its worst month during the period studied.
Exhibit 2: Cash investments are the least risky of the defensive assets
|Worst month||Volatility*||Number of months with negative return||% of months with negative return|
* Volatility is calculated as the annualized standard deviation of monthly returns.
Monthly data 1990-2015 from Morningstar Direct.
Source: Charles Schwab Investment Advisory, Inc. and Morningstar Direct. Based on nominal monthly data from 1990 to 2015. Indexes do not have fees or expenses and cannot be invested in directly. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results. Indexes used
Cash investments also provide meaningful diversification relative to riskier asset classes such as stocks. The difference that a diversified portfolio can deliver over the sum of its parts is what Nobel Prize-winning economist Harry Markowitz once called "the only free lunch in finance." In other words, diversification can deliver benefits over time at no additional cost.
This "free lunch" is made possible by the fact that individual assets typically aren't perfectly correlated. If asset values do not move in perfect harmony, then a diversified portfolio will have less risk than the weighted average risk of its constituent parts. In fact, a diversified portfolio can often have less risk than its lowest-risk constituent.
The diversification benefits associated with combining assets into a portfolio are driven primarily by how closely the returns on those assets move together. When two assets are perfectly positively correlated (correlation of +1), there are no benefits from combining them in a portfolio. When two equally risky assets are perfectly negatively correlated (correlation of -1), combining the two assets into a portfolio can eliminate all volatility. A correlation of zero means that the two assets are uncorrelated and don't move together at all.
In reality, no two assets are perfectly correlated—either positively or negatively. In practice, most correlations are positive, and investors should seek investments with lower correlation to one another. Relatively few assets have low or negative correlations with each other. However, as a result of its low volatility, cash is an asset class that tends to have lower correlations relative to all other asset classes.
Cash investments are the best diversifier of stock market risk
As illustrated in Exhibit 3, cash investments had the lowest average correlation relative to stocks among the defensive asset classes examined. The average annualized correlation between cash investments and stocks was -0.023 over the period from 1990 – 2015. The defensive asset with the next lowest correlation relative to stocks was gold, with an average annualized correlation of -0.01. While gold provided a similar amount of diversification as did cash investments, that diversification came with the price of gold's significantly higher volatility, as shown earlier. Each of the other defensive asset classes also had slightly higher correlation with stocks as well as higher volatility historically.
Additionally, cash investments showed the most stable correlation relative to stocks over the period examined, as measured by standard deviation of annualized correlations. Correlations among asset classes can be highly unstable over time. And in times of market stress, correlations among asset classes tend to rise significantly, providing the least amount of diversification at precisely the time when investors need it most. Given that instability, it is notable that cash delivered the most stable correlation over time, with a standard deviation of the annual correlation of cash investments relative to stocks at 0.27% over the period from 1990 to 2015.
We acknowledge that the other defensive asset classes also had relatively low standard deviation of correlations. However, cash investments held the top ranking of both lowest average annual correlation as well as most stable correlation over time, demonstrating that it was the strongest diversifier of stock market risk relative to the other defensive assets.
Exhibit 3: Cash investments have had the lowest average and most stable correlation with stocks
|Average annual correlation||Correlation stability|
Source: Charles Schwab Investment Advisory, Inc. and Morningstar Direct. Based on monthly data from 1990 to 2015. Correlation is calculated for each calendar year using monthly data. Average annual correlation is the average of each annual correlation over the period. Correlation stability is calculated as the standard deviation of each annual correlation over the period. Indexes do not have fees or expenses and cannot be invested in directly. Indexes used
Cash investments are an all-purpose diversifier
Also notable is that cash investments represent an all-purpose diversifier relative to other asset classes—not just stocks. Exhibit 4 shows the average correlation for each asset class relative to all of the other asset classes. As the chart illustrates, among all of the assets examined, cash had the lowest average correlation relative to all the other asset classes.
Exhibit 4: Cash has the lowest average correlation relative to all other asset classes
(Each asset's average correlation with all other assets)
Source: Charles Schwab Investment Advisory, Inc. and Morningstar Direct. Based on monthly data from 2004 to 2015. Correlation is calculated for each asset class relative to all other asset classes over the full period. Indexes do not have fees or expenses and cannot be invested in directly. Past performance is no guarantee of future results. Indexes used
Cash investments are the most consistent diversifier through time
Exhibit 5 underscores the consistent diversification that cash investments have provided relative to all other asset classes. Among the defensive asset classes shown, cash had the lowest average correlation relative to all other asset classes for each of the time periods shown.7
That consistency of diversification was the case in each of three different market environments over the past decade:
- 2004–2007, when markets were advancing and interest rates were generally rising. In this environment, cash was the defensive asset with the lowest average correlation relative to all other assets.
- 2008–2011, a period marked by extreme market volatility and falling interest rates. Cash actually had a meaningfully negative average correlation with all other asset classes during this turbulent period, indicating that it provided a significant source of diversification when most other asset classes were experiencing sizable declines in value. Ultrashort bonds and Treasuries also had a negative average correlation relative to all other assets during this period, but meaningfully less than cash.
- 2012–2015, when markets were volatile at times but generally rising, and interest rates and inflation remained at low levels. Cash was the only one of the defensive assets that had a negative average correlation relative to all other assets during this period, providing the greatest diversification benefit.
Exhibit 5: Cash investments are the most consistent diversifier
(Each defensive asset's average correlation with all other assets)
Source: Charles Schwab Investment Advisory, Inc. and Morningstar Direct. Based on monthly data from 2004 to 2015. Correlation is calculated for each calendar year. Indexes do not have fees or expenses and cannot be invested in directly. Past performance is no guarantee of future results. Indexes used
While inflation has been below the Federal Reserve's 2% target in recent years, inflation can corrode investor wealth over time and has historically presented a meaningful risk. For example, in the 1970s and 1980s, annual inflation rates reached double-digit levels. And while most forecasts don't call for inflation to return to those levels anytime soon, the Fed does expect inflation to move back toward its target in coming years.
Investors have typically turned to several asset classes to help protect a portfolio from potential inflation: inflation-protected bonds, real estate and commodities. Although cash investments are not typically looked at as "inflation hedges" because of relatively low returns, their very short duration means that their yields adjust quickly to changes in inflation.
Additionally, people often think of cash as simply currency, which might lose purchasing power as inflation rises. However, cash in Schwab Intelligent Portfolios is an investment that is held in a deposit account at Schwab Bank that earns interest. If inflation were to increase, the interest rate on those deposit accounts is pegged to an index that would be expected to change as well.
Cash has helped protect against inflation in both the short and long term
As Exhibit 6 shows, among assets considered to provide inflation protection, cash investments actually have the highest correlation with inflation in both the short and long term. Because cash investments have very short durations, they tend to have minimal negative price sensitivity to rising interest rates, which typically accompany inflation. Additionally, in a portfolio context, the yield on cash investments tends to track upward along with rising inflation.
- Ultrashort bonds delivered a relatively strong correlation with inflation over the longer-term rolling 60-month periods. However, their longer maturities of about one year compared with the shorter duration of cash investments caused them to be less correlated with inflation over the shorter-term rolling 12-month periods.
- Treasury Inflation Protected Securities (TIPS) were introduced in 1997 as a means of protecting against the corrosive impact of inflation. With TIPS, the principal value adjusts upward as inflation rises. As TIPS have a constant coupon rate, this implies that the coupon, or interest received, grows with inflation. TIPS pay interest twice a year, with their principal adjusted based on changes in the consumer price index (CPI), so they tend to reflect changes in inflation relatively quickly. As shown in the chart, TIPS had the second highest correlation with inflation over rolling 12-month periods. However, over the longer-term rolling 60-month periods, TIPS had a lower correlation with inflation. This likely occurred because TIPS yields are determined by investor expectations for future inflation, and over longer periods these expectations can prove to be meaningfully higher or lower than actual realized inflation. Over the period examined from 1998 to 2015 inflation was on a generally downward trend and expectations for future inflation were generally higher than actual inflation.
- Real estate investment trusts (REITs) had a moderate correlation with inflation in both the short and long term, as shown in the chart. REITs are investments in real estate investment trusts focused on real estate and/or mortgages or mortgage securities traded on US exchanges. REITs must pay 90% of their taxable income to shareholders every year. Since dividends from REITs generally increase with inflation, REITs tend to do better than most other asset classes in moderate or high inflation environments. REITs do poorly during recessions as occupancy rates and valuations may both fall in such environments. REITs also tend to do poorly during periods of rising interest rates when that rise isn't accompanied by higher inflation. Lease rates and real estate prices do not immediately adjust to inflation so the benefits of REITs as an inflation hedge may not be apparent when correlations are calculated over short horizons.
- Commodities such as gold tend to perform well when expectations for future inflation are increasing, the US dollar is falling, geopolitical unrest is rising, or there are widespread concerns about the stability of the financial system. As shown in the chart, gold was among the assets with a relatively high correlation with inflation over both the 12-month and 60-month rolling periods, although still lower than cash in each period.
Exhibit 6: Cash investments are an effective inflation hedge relative to other asset classes
Source: Charles Schwab Investment Advisory, Inc. and Morningstar Direct. Based on monthly data from 1998 to 2015. Indexes do not have fees or expenses and cannot be invested in directly. Past performance is no guarantee of future results. Indexes used
Cash investments have historically delivered higher returns when inflation was high
Although interest rates and inflation are at generationally low levels today, it is instructive to remember that this environment is a relatively recent phenomenon. With the Federal Reserve beginning to normalize monetary policy and raising short-term interest rates in 2015, interest rates could be headed higher going forward. In an environment of potentially higher interest rates and higher inflation in the future, cash investments may see higher yields and may provide more of the income potential they have delivered historically.
As Exhibit 7 illustrates, in historical periods when inflation has been high, the return on cash investments has also been relatively high. Over the period from 1970 to 1985, when inflation rose into double-digit territory, the return on cash rose along with inflation. And over the full 15-year period, the average return on cash of about 8% was higher than the average rate of inflation at approximately 7%.
Exhibit 7: When inflation has been high, the return on cash investments has been high
Source: Charles Schwab Investment Advisory, Inc. and Morningstar Direct. Based on annual data from 1970 to 1985. Indexes do not have fees or expenses and cannot be invested in directly. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results. Indexes used
Cash Allocations in Schwab Intelligent Portfolios
The cash allocations in Schwab Intelligent Portfolios vary according to an investor's risk profile, with the least risky portfolios holding the most cash and the riskiest portfolios holding the least cash. For example, as illustrated in Exhibit 8, the targeted cash allocations included in the total return versions of the portfolios ranges from approximately 6% to 29% of an account's value, depending on the portfolio selected as determined by an investor's risk profile.
Investors earn interest on this cash allocation through the Schwab Intelligent Portfolios Sweep Program. This program provides investors access to the Schwab Bank Savings Sweep feature—a brokerage service that automatically deposits, or "sweeps," cash balances into deposit accounts at Charles Schwab Bank, an FDIC-insured depository institution.
The interest that the deposit accounts at Schwab Bank earn is determined by reference to an index. Currently, that index is the national average of rates paid by all insured depository institutions as calculated by RateWatch. The interest rate is set on the first business day of each month and effective through the last business day of that month.
Exhibit 8: Target cash allocations are determined by an investor's risk profile
Target Cash Allocation (%)
Source: Charles Schwab Investment Advisory, Inc.
How Cash May Benefit Portfolio Returns vs. Cash Substitutes
In assessing how a cash allocation might affect expected returns, some people simply assume that the cash allocation would earn the return of the rest of the portfolio if it were not held in cash. This is a flawed analysis. Simply redistributing the cash allocation proportionally across the other assets in the portfolio would alter the investor's risk profile. This flawed assumption ignores the actual composition of the portfolio, making the comparison meaningless. A portfolio that was fully invested in equities might have a high long-term expected return. But that return would come with more volatility than most investors could withstand and depending on their time frame, would insert a significant risk of capital loss. Ignoring risk and only considering potential return is unwise. This is the foundation of Modern Portfolio Theory.
A valid analysis would consider whether other investments, such as short-term Treasuries, were being used as cash substitutes in the portfolio to provide the ballast that cash can deliver. This is typically the case. So a more accurate analysis would consider how using one of these cash substitutes in place of cash would affect the portfolio's expected returns.
Don't ignore how advisory fees reduce returns
Fees add up over time and create a drag on investing performance. Investors should be conscious about trying to avoid paying unnecessary fees that eat into investment returns. Fees are an important component of any investment model when paying for important benefits (customization, wealth management insight, assessment, planning, etc.) but if given an option between an additional layer of fees for automated investment services without additional benefit, versus not bearing the burden of those fees, avoiding those fees is a better way to go. That's why Schwab Intelligent Portfolios charges no advisory fees, no trading commissions and no account service fees.
Because expenses and fees matter, these must be considered in the analysis as well. Cash – as it is used in Schwab Intelligent Portfolios- does not include an operating expense or management fee, in fact it earns interest. 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 advisory fee is included on top of that, our analysis finds that the portfolio with the cash allocation would be superior in nearly all scenarios.
The following analysis considers several hypothetical scenarios examining how cash compares with an alternate short-term investment, factoring in the effect of ETF operating expenses as well as an advisory fee. You be the judge.
What is the impact on expected returns if ultrashort Treasuries are used instead?
Our first 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 0.50% on an annualized basis. The expected return spread does exceed the ETF management costs. 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.
Exhibit 9 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 advisory fee.
- Ultrashort Treasury ETF OER: 0.15%
- Advisory fee for the entire portfolio: 0.25%
- Gross expected return spread of ultrashort Treasuries over cash: 0.50%
Exhibit 9: Impact on Schwab Intelligent Portfolios Return Applying an Advisory Fee and Using Ultrashort Bond ETF as a Cash Substitute Using Forward-Looking Return Expectations.
vs. Cash Allocation
Note: Exhibit 9 is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product or portfolio.
The "Return Difference vs. Cash Allocation" is calculated as = ((Return Spread-OER) * Cash Allocation) – Advisory Fee. For example, for the Conservative portfolio:
This shows that the alternate portfolio using ultra-short Treasuries actually would have a lower return than the portfolio with cash by about 0.20%. 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?
Ultrashort Treasuries are not the only potential cash substitute. Some might instead use a short-term Treasury ETF. These typically focus on Treasuries with a maturity between one and three years. Exhibit 10 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.
- Short-Term Treasury ETF OER: 0.15%
- Advisory fee for the entire portfolio: 0.25%
- Gross expected return spread of short-term Treasuries over cash: 1.10%
Exhibit 10: Impact on Schwab Intelligent Portfolios Return Applying a Management Fee and Using Short-Term Bond ETF as a Cash Substitute Using Forward-Looking Return Expectations.
vs. Cash Allocation
Note: Exhibit 10 is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product or portfolio.
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 2015, ultra-short Treasuries experienced 38 months with negative returns, a little more than 12% of months during the period. And short-term Treasuries experienced 66 negative months, or 21% of months during the period. By contrast, cash experienced no months of negative returns during the period.
What is the impact on expected returns if we use current yields in the analysis?
Charles Schwab Investment Advisory's capital markets expectations were used to build Schwab Intelligent Portfolios. However, we recognize that not every firm will have the same opinion about the expected future performance of the different asset classes. To account for this, rather than using CSIA's expectations we can perform the same calculations as above but use the current yields of cash, ultrashort Treasuries and short-term Treasuries.
Exhibit 11 shows the results.
In both cases we use the following assumptions.
- OER of the ETF used as the cash substitute: 0.15%
- Cash yield as of December 31, 2015: 0.08%.
- Advisory fee for the entire portfolio: 0.25%
|Return Difference vs.
12/31/2014 Yield = 0.12%
12/31/2014 = 0.68%
Note: Exhibit 11 is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product or portfolio.
Using the assumptions described above and yields-to-maturity as of December 31 2015, the results for ultra-short bonds are similar to the results from Exhibit 9. This means that ultra-short Treasuries as a cash substitute are not attractive in any portfolio under either scenario. Stated differently, the negative numbers in column 4 of Exhibit 11 and Exhibit 9 mean that the higher yield of ultra-short Treasuries is more than offset by the advisory fee and the OER of the ultra-short ETF used.
Turning our attention to column 5 of Exhibit 11 and the short-term Treasury case, we see that using short-term Treasuries as a cash substitute was also similar to when we used CSIA's forward projections.
At Charles Schwab, we understand the important purposes that cash serves within investment portfolios. Cash investments are an important allocation within a well-diversified investment portfolio that includes other asset classes such as stocks, bonds and commodities. Cash investments can serve as a solid foundation for the portfolio, adding stability and diversification relative to other asset classes focused on potential growth over time. Along with the important property of risk reduction that cash provides, our analysis shows that a cash allocation would provide, in most cases, a superior expected return relative to cash substitutes when the true costs of those substitutes are considered and does not result in a drag on portfolio returns. For these reasons, Schwab Intelligent Portfolios includes meaningful allocations to cash, with the amount of cash held in an investor's portfolio determined by their investment goals, time horizon, and both capacity and willingness for risk.
1. For more information about the Schwab Bank Sweep Program, see "Schwab Intelligent Portfolios Sweep Program Disclosure Statement," January 2015.
2. The current rate and RateWatch's methodology can be found at www.rate-watch.com/national-averages.
3. More information about federal deposit insurance can be found on the Federal Deposit Insurance Corporation (FDIC) website at www.fdic.gov.
4. Kahneman, D. and Tversky, A. (1984). "Choices, Values, and Frames". American Psychologist 39 (4): 341–350.
5. Fjelstad, Mary, "Recessions and the U.S. Equity Market," Russell Research, February 2012.
6. Morningstar magazine, "Trends," April/May 2014, pg. 19.
7. The reference to "all other asset classes" includes the same list of asset classes included in Exhibit 4.