Investors should be putting excess cash to work or at least know why they are holding on to their money when it isn’t riding out the markets in a stock or bond exchange traded fund.
Samuel Lee, ETF strategist with Morningstar, points out three ways to use cash: hold until opportunities arise, invest in traditional asset classes, or track skill-based strategies.
First off, investors can sit on their cash positions in hopes of capitalizing on a market bottom.
“The true value of cash is its ability to buy assets on the cheap during bad times,” Lee said. “Most investors don’t have the nerve and patience to do this.”
However, with the equities market rallying to higher highs, investors could do well with a moderate cash position, instead of trying to pick stocks in their current high valuations and greater possibility for a pullback.
“I’ve been keeping about 10% of the ETFInvestor model portfolios in cash for these reasons and, unlike many of my subscribers, I am considering raising even more cash,” Lee added.
Lee also warns smaller investors against “cashlike” short-duration bond ETFs, arguing that investors should only use them “if you’re managing a portfolio so large it’s not worth dealing with FDIC-insured accounts.”
Additionally, Lee suggests investors should invest in “betas,” or traditional asset classes, but as mentioned, most options look fairly expensive. He points out that investing in betas is an “implicit bet on low interest rates continuing.” If rates spike, prices on all assets with cash flows will begin to dip.
“Of the betas, emerging-markets equities are among the cheapest,” Lee said. “They yield about 3% and have the potential to grow their dividends at a decent clip.”
Emerging market ETFs have been underperforming compared to the U.S. markets so far this year. The iShares MSCI Emerging Markets ETF (NYSEArca: EEM) is down 10.0% year-to-date and Vanguard FTSE Emerging Markets ETF (NYSEArca: VWO) declined 9.4%, whereas the S&P 500 Index has gained 19.8%. [Technical Signs Point to Emerging ETF Rotation]
Lastly, cash can be put to use in “alphas,” or excess returns generated from skill-based strategies that take advantage of relative mispricings. For instance, investors can pick out actively managed ETF strategies, along with passive “enhanced” or “smart-beta” index ETFs that follow active styles, such as fundamentally weighted or equal-weight index ETFs. [Some Outperforming ‘Smart-Beta’ ETFs]
“If you have an edge, you should be exercising it as aggressively as possible, regardless of the expected returns of betas,” Lee said. “If you don’t, then you should avoid alpha bets.”
For more information on investing in ETFs, visit our ETF 101 category.
Max Chen contributed to this article.
Full disclosure: Tom Lydon’s clients own EEM.