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Consumers aren't alone. Financial planners, too, are expressing heightened interest in cash as an asset class. "Our new money for fixed-income allocations is going into cash equivalents," says Mal Makin, president of Professional Planning Group in Westerly, R.I. "I just met with someone who has a $1.8 million portfolio. He has a 40% allocation to fixed income and that's all going into six-month Treasuries and one-year paper, including jumbo CDs.
"Rising rates have allowed us to use cash more effectively," Makin continues. "We have not had to look for alternatives to house the percentage of clients' assets we want to hold in cash."
In a year when equities have been flat, the real estate bubble is deflating and the Federal Reserve raised interest rates for the 17th time, cash is more than a safe haven. In fact, these days cash is getting extra room in clients' portfolios. "Six months ago," says Makin, "two-year bonds were yielding more than 10-year bonds. Even now, the yield curve is flat. So we're keeping fixed-income holdings under one year until the yield curve gets back to normal and we can build bond ladders out to five, six and seven years."
Thus, cash offers clients a way to have a fixed-income allocation without being exposed to rising interest rates. Higher yields on cash also may have an impact on the equity side. "We used to put clients' money to work within 60 days," Makin says. "Now we're dollar-cost averaging into the market over six months." With 5% interest rates on cash reserves, the price of caution may be scant. Indeed, Makin is prepared to back off from equities in favor of cash if yields on low-risk instruments go appreciably higher.
A NEWLY VERSATILE ASSET CLASS
The bottom line, then, is that cash has become a much more versatile asset class in today's relatively high-rate environment. (We're still a long way from 1981, when money market funds were yielding 17%.) Besides holding cash for spending and for possible emergencies, many investors also include cash positions in their portfolios. "Cash is especially important in tumultuous markets, particularly if the Federal Reserve is indicating that inflation is not under control," says Kathleen Grace, director of family office services at Carl Domino, Inc., an investment management firm in Palm Beach and Boca Raton. Higher inflation is likely to generate higher interest rates, which may in turn weaken stock and bond markets while raising the yields on cash equivalents.
Grace says that she uses various taxable and tax-exempt vehicles for this cash position. "For the past year, I've been using Schwab YieldPlus Fund, which has worked very well for taxable accounts. The yield has been attractive and this fund has avoided erosion of principal, so it has been a good alternative to a money market fund. Some of my clients might hold 25% to 35% of their portfolios in this fund now." Classed as an ultra-short bond fund, this $8 billion-plus Schwab entry recently was boasting a yield over 5%.
YieldPlus manager Kim Daifotis reports that his fund's price stayed within a 10-cent-per-share range since 2003. "When rates go down, money market funds will see yields drop sooner than ultra-short funds will," he says, adding that his fund has maintained its principal during a period of rate hikes and may do comparatively well when rates fall, too.
"Now is a good time to hold this type of fund," Grace says. "We're waiting to see what the Fed has to say. If inflation seems to be in check and the Fed will hold the line on rates, it might be a good time to unwind some cash positions. We may buy equities and bonds with attractive valuations."
Used for defensive purposes, cash--and near-cash holdings such as ultra-short bond funds--can provide safety and yield for a while. "A cash reserve lets you take advantage of opportunities in fixed-income and equities," says Phil Luccock, who heads Financially Speaking, a wealth management firm in Highlands Ranch, Colo.
At the beginning of 2006, Luccock recalls, his firm's clients had little cash and an almost total exposure to equities, particularly small cap, mid-cap and foreign issues. In May, he took profits and moved 50% to 60% of client assets into cash. "We started out holding cash in a money market fund," Luccock says. "But we soon put most of that money into Schwab's YieldPlus." The fund also has tax-exempt versions, which Luccock uses in some taxable accounts.
In July, Luccock made further changes, cutting back on the Schwab fund in favor of Pimco Real Return Bond Fund, which holds Treasury Inflation-Protected Securities, and Federated International High Income, an emerging markets bond fund. "The Pimco fund provides some inflation protection, while the Federated fund gives you exposure to emerging markets with less volatility than you have in stocks," he says. Within the next few months, Luccock might trim his cash reserve further.
A NEW WAY TO UNCORRELATE?
Luccock trimmed equities in favor of cash en route to building diversified fixed-income portfolios for his clients. When moving away from equities, there may be no better asset class than cash, according to Tim Chapman, chief executive officer of PMFM, an investment advisory firm in Athens, Ga.
"The world is much smaller now," says Chapman, "and markets are much more correlated than they have been. "Last May, when our indicators turned negative for U.S. stocks, they were negative for all 91 markets that we follow. When we see that kind of correlation, we're more apt to go into cash than we have been." That is, in the past an investor who was bearish on U.S. equities might move money into British or Japanese or Brazilian stocks. There may be times in this globalized era, though, when there is nowhere in the world with good prospects.
"By late May, our models all held their maximum cash positions, up to 100%," Chapman says. "In some situations, cash is the only place to hide." Equities have looked more promising lately, he says, so he is once more back in the stock market. Now that cash can pay upwards of 5%, however, holding large amounts of cash from time to time will not shrivel investors' returns.
As always, there are contrarian viewpoints. Just as the time to exit domestic large-cap stocks was when they peaked in early 2000, it might be wise to move out of cash at 5%. "We were in cash for a while," says Paul Gydosh, managing director of Kensington Wealth Partners in Columbus, Ohio. "We were concerned about owning bonds when interest rates were rising but we're much less worried now. So we've reduced our cash and moved into fixed-income positions."
Gydosh downplays the role of cash reserves as a source of ready funds. Keeping any more than four months' worth of income liquid is an "emotional decision," as he puts it.
"We encourage our clients to take out home equity lines of credit," Gydosh says. "Even if they're not tapped, they can represent a source of liquidity, if needed. With lines of credit, clients are not forced to liquidate stocks, bonds or real estate at the wrong time just to raise cash."
WHEN INTEREST RATES TOP OUT
Mary McGrath, executive vice president of Cozad Asset Management in Champaign, Ill., voices similar thoughts on the waning appeal of cash. "I believe we're near the end of the Fed's interest rate increases for now," she says. "I'm now more interested in fixed income than cash. Money market yields might go down if the economy weakens and the Fed starts to cut interest rates. Therefore, for money that's not needed right away, I'm locking in 5.3%, 5.5% and so on with three- to five-year CDs."
Indeed, Greg McBride, senior financial analyst at Bankrate.com in West Palm Beach, says that three- to five-year CDs "really stand out" in the current environment. "Yields are at five-year highs now," he says. "If time horizon is not a concern, you can lock in these risk-free returns. Such CDs will be especially attractive if the Fed hits the pause button on interest rates, as many people expect."
Not everyone is buying longer-term CDs, though, as the Lipper numbers on money market flows indicate. "In our experience, asset allocators will generally hold from 5% to 20% in cash over an economic cycle," says Debbie
Cunningham, chief investment officer, taxable money markets, for Pittsburgh-based Federated Investors. "Now, it looks like the Fed is at or close to a peak when it comes to raising interest rates. A recession isn't being forecast, so few people are predicting that rates will fall soon. A plateau is more likely so this may be a good time to maximize cash holdings. A lot of planners are either at their maximum allocation to cash or ramping up to get there."
YOU CAN TAKE IT TO THE BANK
How are planners moving into cash? "Not so much in Treasury bills, which are expensive these days," Cunningham says. "There has been more interest in bank products."
That interest is apparent at ING Advisors Network, a group of four broker-dealers. At three of these B-Ds, reps have a relationship with ING Direct, an online bank that heavily advertises its savings products. (At PrimeVest Financial Services, the fourth B-D, reps work with banks and credit unions. They don't refer clients to ING Direct.)
"Our business with ING Direct has been growing at 18% to 25% a year, and those assets are now over $1.6 billion," says Valerie Brown, president of ING Advisors Network in Atlanta. "ING Direct has CDs at competitive rates but our business has been primarily in day-to-day accounts, which are just like old passbook accounts." The no-fee, no-minimum Orange Savings Account provides liquidity, federal deposit insurance and (at press time) a 4.4% annual percentage yield.
Although they don't provide a federal safety net, money market funds have even higher yields these days. "Assets in money market funds had declined from 2003 to 2005," Cunningham says, "but that has been reversed this year." Loftier payouts have added to the appeal.
PMFM's Tim Chapman, for example, uses various money market funds when he moves from other asset classes to cash. "We have one eye on safety when we go to cash, and we don't want to take any interest-rate risk," he says. Even short-term bonds can lose some principal if rates rise.
Mary McGrath also uses money market funds for clients' positions. "We do not want to be creative with cash," she says. "For clients in the maximum tax bracket, we may use tax-exempt money market funds."
Going by the math, tax-exempt money funds are only suitable for those in the very highest bracket. According to the Money Fund Report newsletter, published by iMoneyNet, the highest seven-day compound yield among retail taxable general-purpose money funds recently was 5.28%. That would leave a top tax-bracket investor with 3.43%, after paying 35% to the IRS. The highest seven-day compound yield among retail tax-free money markets was the same 3.43%. In any lower bracket, investors will net more with a taxable money fund. Of course, in high-tax states such as California, New York, Ohio, Pennsylvania and Georgia, a client might be best off in a single-state, triple-tax-exempt money fund.
There can be more to this decision than after-tax yield. "Some investors just like the idea of being in a fund that buys municipal securities," Cunningham says. "They think governments are more creditworthy than the corporations whose paper is held by money market funds. And some investors just prefer not to pay income tax."
EXOTIC CASH EQUIVALENTS
Beyond money market funds, Cunningham mentions auction-rate securities as an alternative to cash. These floating-rate securities are gaining popularity, she says: "Auction-rate securities have a slightly higher yield, compared with tax-exempt money market funds, and they haven't had any defaults since the early '90s. Some investors might want to diversify cash holdings among money market funds, auction-rate securities and ultra-short bond funds."
Bill Meyers, a vice president and product manager at Nuveen Investments in Chicago, says that his firm has about $15 billion worth of auction-rate securities outstanding, of which $11 billion are tax-exempt municipal issues. They're used mainly as short-term paper to leverage some Nuveen closed-end bond funds. That is, Nuveen can pay short-term rates on auction-rate preferred shares while using the money raised to buy longer-term bonds for the funds.
"Historically, the yields on auction-rate preferreds have been around 35 to 40 basis points higher than yields on tax-exempt money market funds," Meyers says. There are some risks, such as defaults and a possible shortage of buyers, but these securities generally have delivered safety and liquidity in addition to higher payouts.
Shares are usually priced at $25,000, which is the minimum investment, Meyers adds. They can be redeemed every seven days, at auctions that determine the new interest rate. Financial planners probably can get access to these securities and guidance to the purchase procedure through their clearing firm.
Diversification among various forms of cash and cash substitutes may provide a good mix of current yield and principal preservation. A recent addition to such a mix could be the year-old JPMorgan Tax Aware Real Return Fund, which combines intermediate-term municipal bonds, for tax-exempt income, with derivatives ("swaps") on the Consumer Price Index, for inflation protection.
"The municipal yield curve is steeper than the taxable curve," says Deepa Majmudar, co-manager of the JPMorgan fund. "So the yield from our fund will generally be higher than the yield from tax-exempt money market funds. It's also less volatile than an intermediate-term municipal bond fund because the inflation-linked securities can offset any price loss. Our fund can be a good diversifier."
Considering all the varied offerings on the market, planners have a great deal of flexibility in tailoring clients' cash and near-cash positions. One area, though, can be beyond planners' control: cash held by the managers of stock and bond funds.
According to Morningstar, equity funds' cash holdings now average around 5%, a portion that has held steady for the last several years. Taxable bond funds, though, now hold about 14% in cash, on average, up sharply from the 7% to 8% levels of 2001 and 2002. A few specialty categories, including natural resources, precious metals and Japanese stock funds, also report sharply higher cash holdings compared to those of four or five years ago.
Several diversified equity funds are willing to let their cash hoards build as well. A few examples: Clipper Fund was holding 19% of its assets in cash, as of the latest Morningstar report; American Funds Amcap was at 18%; Janus Twenty was over 13%. As long as these positions remain in place, investors are not getting full exposure to equity markets.
"Many advisors are not interested in fund managers who raise cash," says Christine Benz, director of fund analysis at Morningstar. "A large cash position could be good or bad, however. You need to look at a manager's strategy. Since the last bear market, a lot of managers recognize that holding cash is not always a terrible thing. A large cash position may mean managers are not finding anything to buy; so they're sticking to their discipline and waiting for buying opportunities. If you always avoid managers who go to cash, you shut yourself off from some good ones."
By the same reasoning, if some good fund managers go to cash periodically, awaiting better entry points for stocks or bonds, some planners, too, may find occasions to park clients' money in cash. Such parking comes with a plump payout these days--so planners may find themselves taking a longer look at the short end of the yield curve.
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