Cash holdings in an investment portfolio - strategies to squeeze income

It is customary for investors to hold sizable amounts of cash in their portfolios. This cash-hoard is especially beneficial to investors when the market is over-extended and/or uncertain:

  1. Keeping the powder dry: Dry powder ensures opportunity to swoop for the kill when the conditions are right. Such opportunities do come by every few years and cold hard cash is required to place significant bets that can pave way for later rewards. Margin funds available in a brokerage account should not be considered for this purpose as the high interest rate takes a generous chunk from the returns – in fact, it is recommended to steer clear from margin funds as far as possible, independent of the market conditions.
  2. Buffering correction impact: A popular investment strategy is staying fully invested on the long-side. More often than not, if the market experiences a 20% correction, the portfolio mirrors that to a large extend. But this correction impact could have been lowered had a percentage of the portfolio been in cash. For e.g., consider a $100K portfolio fully invested in a total market index fund. A 20% market correction reduces the portfolio value to $80K. But, if 20% of the portfolio was in cash, the value would go down only to $84K buffering the impact of the correction.
  3. Trouncing the market average performance: Aspiring to stay fully invested when the market is valued at a significant discount to estimated fair values and raising cash when the margin of safety goes down is a surefire way of beating market averages. Investing the cash-hoard when the margin of safety is compelling has the advantage of the newly invested funds giving a much higher ROI compared to the rest of the portfolio. In effect, the overall portfolio gets a significant boost that should help beat the averages.
  4. Realizing absolute returns: Rather than market tracking strategies, a variation on the above is to hold cash with an eye towards realizing absolute returns. Holding cash allows one to go long when the market is in the doldrums thereby allowing focusing on absolute returns. Further, extending such a strategy to going for selective selling of over extended securities raises cash thereby allowing one to reload for an eventual market downturn.

The cash hoard is not without downsides – the obvious one is that it is tough to beat inflation in that part of your overall portfolio. Independent of the interest rate environment, keeping your cash hoard liquid while earning a good return on it is a holy-grail.

Below is a look at the common options available within US brokerage accounts:

  1. Money-market sweep: Typical brokerage money market sweep accounts offer dismally low interest rates – in the 0.05% range for our TD Ameritrade and E*Trade brokerage accounts – i.e. a $100K average cash balance in the portfolio will give a grand total annual return of ~$50. In a higher-interest rate environment, they might offer faintly better returns, but nothing of substance. The advantage with the money-market sweep offering is that generally sign up is not required and the balance is very secure – FDIC or SIPC coverage exists on balances up to $250K kept in a sweep vehicle. Certain brokerages also offer double the coverage (up to $500K) as they distribute the cash held between two bank accounts which each offer $250K of coverage. 
  2. Savings account sweep: Savings sweep accounts offer substantially better interest rates but still  well below prevailing inflation rates – in the 0.25% range for our TD Ameritrade and E*Trade brokerage accounts. The balances kept in such accounts offer similar protection as money-market sweep offerings making them also very secure. The downside though is that transfers back-and-forth can typically take upwards of a day, depriving one of the ability to take advantage of a market spike.
  3. Fixed deposit account based mutual funds, Mutual funds indexed to treasury bonds, and other AAA rated bond funds: These generally offer an income stream upwards of 2% making them a good option for US residents. High quality muni bond funds are another option suitable for taxable accounts. One disadvantage is that capital preservation is not guaranteed - one can minimize this risk by going with high-quality (AAA rated) options with low duration. Restrictions in purchasing US mutual funds by non-residents are a stumbling block for non-resident US citizens. For non-residents, there are a number of ETFs that offer similar risk/reward. Floating-rate income trust ETFs (EFT, BSL, PPR) that invests in senior secured floating-rate loans, MLP ETFs (NTG, CEM, EMO), etc are other choices although preservation of capital is only a secondary objective for such products.
  4. Arbitrage: This strategy requires a global trading account as opposed to a trading account for US markets only. Global trading accounts allow transferring money and investing in major global markets. This opens up arbitrage opportunities – basically, one could transfer a portion of the assets to another currency which offer better interest rates and if the exchange rate remains stable during this capital allocation, you come out ahead compared to holding the money in USD which offer meager rates. Transaction & transfer costs can both reduce the returns and capital risk is a concern as well...
  5. Stable high-yield stocks: These offer the best potential returns but with the downside that capital preservation is subject to the vagaries of the market. Even so, investing in dividend paying stocks with a high margin-of-safety is a far better option compared to many of the alternatives. A variation on this strategy is combining long-dated protective puts with short-term (~90 days)  near-the-money covered calls: the strategy provides downside protection with funding for such protection covered by the cash realized from the calls. Keeping a list of such stocks and picking from them on a perpetual basis to implement this strategy can work very well, especially in a low-interest-rate environment. An example using General Electric (GE) stock showed a projected income stream of around 11% annualized with minimized risk because of the protective puts: The stock currently trades at $16.80. Long-dated puts two years out are priced in the $3.80 range while short-dated calls three months out are priced in the $0.78 range. The difference between the defensive put premium and the cash realized from the covered calls should be in the $1.22 range based on a calculation that assumes constant stock price over the period ($0.78*8 - $3.80 = $2.44/2 = $1.22). That is an annualized return of ~7% and the stock is yielding ~4% giving an almost guaranteed total return of ~11%. 

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