ETFs can be a good option for an investor who has a large temporary cash position. This is because large cash balances may tilt an investor's portfolio away from its targeted allocation to equities or fixed income. And over extended periods this can result in performance shortfalls relative to benchmarks or financial goals. Why is this? Historically, equity and fixed income markets have had more periods of positive returns than periods of negative returns.
The longer the time period, the stronger this performance bias. Investing a large temporary cash position in ETFs reduces the likelihood of such performance shortfalls. Let's look at an example. In this hypothetical case, an active equity manager used to keep a cash buffer of around 3% to fund new trade ideas and meet frequent cash flow needs. This resulted in a significant cash drag of more than 2% due to strong momentum in equity markets.
The asset manager decided to equitise the cash allocation with an equity ETF to minimise the cash drag. It is worth considering that equities or bonds could underperform cash during the transition period and that trading costs may offset some of those potential advantages.
