Use ETFs to hold your cash

Sitting in cash is rarely a good investment strategy. So what’s the alternative?

Advisors typically deploy their clients’ cash holdings into higher-yielding investments, such as money-market funds or high-quality bonds. The problem is interest rates are so low that these strategies are practically the same as sitting in cash (see “Traditional ways to deploy cash,” this page).

High-interest savings accounts are a better alternative to money-market funds, but their paltry yields currently average 1.20% in Canada, and depending on the provider, come with a lot of strings attached, including minimum and maximum investment thresholds and hefty withdrawal fees.

Another problem is the low yield. But for a client who has an immediate need for cash and can’t afford any principal risk, this is probably the best place to invest.

Better cash alternatives

If an investor is willing to take slightly more risk with the conservative portion of their income portfolio, there are richer rewards.

Consider the DEX Short Term Bond Index, which is an index measure of shorter-term government bonds. It’s currently yielding about 2.85%, more than threefold what a money-market fund does at half the cost. Also, the ETF holds AAA government bonds. Investors can get exposure to this index through a passively managed ETF.

What’s the trade-off for the higher yield? In this case it’s the bond duration, which is almost three years on the DEX Short Term Bond Index ETF versus about three months for a money-market fund.

If rates were to rise rapidly on shorter-term bonds, then the net asset value of the ETF could decline. You’re earning three times the return as a money-market fund, which gives a nice cushion with a very low risk profile.

What if your client doesn’t want to take on any rate risk? Floating-rate corporate or government bond ETFs can substantially reduce the interest-rate risk associated with bond investing.

Typically the risk profile of corporate bonds are too high to be a cash alternative. But with a shorter duration or interest-rate protection they might prove to be a way to increase yield in the cash portion of the portfolio.

Corporate bonds tend to pay higher rates of interest compared to government bonds — referred to as the corporate bond spread — earned by money-market funds, and the interest rate offered on high-interest savings accounts.

Taking on the modest increase in credit and default risk associated with corporate bonds can deliver a better yield.

Some floating-rate bond ETFs manage their portfolio yield so it’s equivalent to the current Canadian Dealer Offered Rate (CDOR) plus the market’s priced-in spread of corporate bonds over government bonds.

As of press time, the three-month CDOR rate was approximately 1.30% and the corporate bond spread approximately 2.50%. If CDOR increases, the ETF’s portfolio yield should also increase, protecting investors from the negative impact of rate increases.

Advisors should consider floating-rate solutions if a fear of rising interest rates is their main hurdle when it comes to investing in higher-yielding bonds.

Foreign money-market funds

Other developed nations can offer short-term treasuries with higher yields than Canadian or U.S. treasuries with a similar risk profile.

The big risk in investing in a foreign money-market fund is currency drift. Most currencies are benchmarked against the U.S. dollar, so the most drastic moves between currencies tend to occur from a relative value basis versus the U.S. dollar.

If you take two economies with a similar level of economic framework, two currencies may move in tandem versus the U.S. dollar. The investor gets a higher rate of return backstopped by a strong sovereign debt rating, and ideally the currency moves are muted.

Traditional ways to deploy cash

	Risk	Current Yield	Duration	Management Expense Ratio
High Interest Savings Account*	Very Low (Principal protected up to $100,000)	1.20%	N/A	N/A
Money Market Funds*	Very Low	0.68% (average)	Approx: 3 months	0.69% (average)
U.S. Money Market Funds*	Very Low	0.09% (average)	Approx: 3 months	0.17% (average)

*Yields and rates posted by Canada’s six largest banks as of December 31, 2012.

This is one area where Canadian ETFs fall short. Mutual funds can give you exposure to foreign treasuries.

In the U.S. there are a number of foreign-currency ETFs that invest in foreign T-bills but are denominated in U.S. dollars. Since the U.S. dollar tends to move against the Canadian dollar, these wouldn’t be appropriate as a money-market alternative.

Advisors could consider ETFs that invest in short-term Australian T-bills. The Australian overnight lending rate is 3% versus only about 1% in Canada. Australia and Canada share many of the same economic drivers, such as resource demand, and both currencies have moved in step with each other against the U.S. dollar.

Regardless of the method, you’re looking for exposure to a foreign currency that has similar credit quality and doesn’t move much against the Canadian dollar, but offers a higher yield.

Keeping costs low and understanding the risk-and-return profile of an investment goes a long way to achieving desired investment results. Focus on these features, and you should be able to deliver better yield to conservative-minded clients than you can with traditional cash and money-market strategies.

Howard Atkinson, CFA, CIMA, ICD.D, is the CEO of Horizons Exchange Traded Funds and author of four books. In 2011, he was named head of the Canadian ETF Association.