One of the most overlooked challenges facing modern investors is having too much unnecessary cash in their portfolio. Among their myriad use cases, exchange-traded funds (ETFs) offer a simple liquidity management strategy that can ensure temporary cash is put to good use.
Let us take a look at this strategy in detail.
Cash Equitization: An Introduction
When it comes to investing, “excess cash” refers to small pockets of money that accumulate over time. This may result from asset turnover or deposits that are never fully allocated to any particular asset. Since cash isn’t allocated to any asset, it just sits there, never collecting any returns.
To overcome the cash drag on their portfolios, investors can employ what’s called a cash equitization strategy. This strategy is designed to accelerate returns by reducing the drag on performance caused by excess cash holdings. By “equitizing” a portfolio, investors monitor their level of unintended cash and use those funds to purchase futures contracts or other derivatives products. By purchasing futures or other derivatives, investors can ensure their investment mirrors the underlying market in which the cash is supposed to be invested.
Of course, this is a simple explanation of how equitization works. In reality, portfolio managers use sophisticated techniques to utilize excess cash holdings as cheaply as possible. This means selecting futures that span several markets, including equities and fixed interest. In any case, monitoring the portfolio’s cash level continuously is necessary to ensure the equitization strategy succeeds. For this reason, it is usually left to professional portfolio managers. Retail investors can certainly pursue equitization, but they must be prepared to monitor their portfolios regularly to ensure proper coverage.
Check out the hidden risks and costs associated with ETFs here.
The Role of ETFs
It’s no secret that liquidity is one of the core institutional applications of ETFs. Exchange-traded funds offer multiple layers of liquidity that make ETFs more cost-efficient to buy and trade than their underlying securities. “According to iShares”:https://www.ishares.com/us/resources/institutional-investors/etf-desk-reference/attributes-and-applications-of-etfs, roughly one-third (32%) of institutional funds use ETFs for cash equitization. This figure is similar for Registered Investment Advisors (RIAs) and as high as 50% for consultants.
The same research showed that more than half of institutional funds, insurers and RIAs utilized ETFs for liquidity management. Forty-five percent of asset managers and family offices and 90% of consultants said the same. Institutions have been using ETFs for equitization and liquidity management since the asset class took off two decades ago. It’s not hard to see why.
Don’t forget to check this article to know more about using ETFs as part of your overall strategic asset allocation process.
Rather than carry a significant cash position, an investor can simply select an ETF that closely approximates their target market and risk exposure. By selecting an ETF, an investor can remain invested with minimal risk instead of carrying cash. This strategy is extremely useful for large institutional investors who are transitioning between managers or searching for a new manager. In this case, equitization through ETFs provides an interim solution as investors adjust their portfolios.
Cash drag is especially detrimental when investors believe that market returns will be positive over time. That’s why so many ETFs employed equitization strategies following the financial crisis, a period known as the longest bull market in history. This often outweighs the only real benefit of retaining cash – namely, reducing risk.
Equitization has proven to be especially useful for institutional bond portfolios because income from bonds naturally increases cash levels more than equity holdings. This makes bond portfolios more susceptible to the cash drag. Combined with low yields on cash, it only makes sense to employ equitization strategies through ETFs. That way, investors can select funds based on a multitude of criteria, including yield, maturity and sector.
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The Bottom Line
For many investors, cash drag is merely an afterthought that isn’t worth fixing. But cash drag costs you a lot over the long run. That’s why so many institutions employ equitization strategies to ensure that opportunity cost doesn’t cost them valuable returns. Beyond the obvious cash drag, ETFs can help you manage liquidity at minimal risk.
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