Guest Post: Where to Go When Cash Is King

James Sanford of Sag Harbor Advisors

James Sanford of Sag Harbor Advisors

With interest rates remaining low, many investors wonder how to evaluate the safety of various places to keep cash. Max invited financial advisor James Sanford of Sag Harbor Advisors, a performance-fee-based wealth manager, to talk about how best to think about choices for cash in a portfolio.


By James Sanford

With the Federal Reserve now expected to wait at least until the December meeting to end 8 years of zero interest rates, and some strategists putting the first lift-off out to March or June of 2016, it’s time to revisit where to put your cash when cash is king. Two-year Treasury notes are now down to 63 basis points. Emerging market weakness in China and commodity-centric nations led to a 12% decline in the S&P 500 from July through September 28, and a surge in the Volatility Index (VIX) to over 40. If you’re with me in the camp to move a substantial amount of the portfolio to cash after the Central-Bank-fueled reversal rally of more than 10% since October 1, it’s important to understand where your broker or advisor places your cash, which is called the “cash sweep.” If swept into money market funds, you’re not in cash at all, but merely a basket of short-term risky securities that earn a paltry yield of zero to 15 basis points.

First, these underlying securities contain corporate credit risk of default like any other corporate bond. Second, there’s no legal guarantee of a “par put” from the manager. Money market funds routinely maintain a fixed $1.00 par value, rather than mark to market, a convenient shell-game trick which completely hides the underlying volatility of the basket of securities in the portfolio, convincing the holder he owns a “cash equivalent.” What he actually owns is a portfolio of risky corporate senior unsecured-debt obligations, which despite their 7, 10, or 90-day maturity, are equal in recovery and default risk to corporate long bonds maturing 10 and 30 years from now. Some money market funds hold tax-free municipal bonds. These are commonly considered “risk free,” which is absolutely not the case, as investors learned the hard way in Detroit, several cities in California and Rhode Island, and, soon, Puerto Rico.

Usually the portfolio in a money market fund doesn’t move at all in price, due to its very short duration. That’s until a shock event hits one of the securities, which was the case with the Lehman Brothers default. Lehman, opened up Monday morning, September 15, 2008, at a bid-offer of $10 to 12 cents on the dollar.  Suddenly this “cash” equivalent lost 90 cents on the dollar. Roughly 35 to 40% of all investment company assets are comprised of money market funds, with 80% of corporations using money market funds to manage their cash balances, and 20% of household cash balances comprised of money market funds, according to a 2009 SEC report.

There is an investor perception that money market funds are insured by the manager due to the “never break the buck” concept. In fact, there is no legal requirement or guarantee that money managers must “never break the buck” or shield investors from losses. Many managers in 2008 compensated investors for losses in money market funds, because it was good for business and they had the capital. Those without the capital, such as the Reserve Fund, did not. Nobody legally had to.

So what advice would I give investors, as a financial advisor? Keep your cash in short-term T-bills? But there is very little if any interest. Take duration risk on longer dated Treasuries?  No.

The answer is more obvious then we think: it’s your common bank savings account. Investors can earn up to 1.1% on internet-only savings accounts that are 100% FDIC guaranteed, a guarantee as solid as U.S. Treasury bonds, yet one that offers overnight liquidity and no duration risk. In fact, investors would have to go all the way to the three-year note to earn a yield equal to the highest available online savings rates of 1.1%.  The counterparty risk of the bank offering the rate is immaterial. As long as it’s FDIC guaranteed, even in the event of an FDIC bank seizure, accounts holders with $250,000 or less, or $500,000 in a joint account for couples, will have unrestricted access to their cash. If the FDIC can’t honor its agreement, all investments will be set to zero. That would be the equivalent of a U.S. government default.

Advisors often don’t like using a savings account as the cash sweep option, as they can’t control the assets. At Sag Harbor Advisors, our clients’ advisor accounts at our custodian are linked via the ACH system to any bank account of their choice, and clients sign over authorization to draw specified funds back to the advisor account should we see market opportunities. For cash holdings that are well north of the FDIC limits, MaxMyInterest is the only way to efficiently manage funds.

Ask your advisor where your cash sweep is, what it’s yielding, and you might find it’s not really “cash” at all.  

 

Tweet about this on TwitterShare on LinkedInShare on FacebookShare on Google+Email this to someonePrint this page