Investors who have shied away from maintaining liquidity allocations due to their low returns are being enticed to reconsider that stance by the currently inverted yield curve. But dispensing with this historical bias against holding “cash” may also offer long-term benefits. With the availability of modern tools like active fixed income exchange-traded funds (ETFs), the value proposition of liquidity-focused strategies improves significantly. These holdings can serve as both stand-alone portfolio components and a practical solution to liquidity constraints. While “cash” by itself may never be a key driver of performance, deploying it thoughtfully may open new paths to efficiency in asset allocation.

The role of liquidity pools in asset allocation

Most institutions maintain a pool of liquidity—typically, high quality, low risk fixed income securities—to satisfy external obligations as they come due. While often referred to as the “cash allocation,” this portfolio sleeve can include bank deposits, money market funds and a variety of short-term fixed income strategies. Because these stable, liquid assets typically offer returns far below an institution’s strategic objectives, investors are required to be parsimonious in how much “cash” they hold. As a result, many institutions retain only enough cash to cover near-term payments and obligations.

Minimizing the cash allocation in favor of asset classes with higher expected returns makes economic sense over the long term. However, doing so shifts the sources of liquidity elsewhere, often to asset classes that are less well suited to the task. Across the broader allocation, price volatility (in corporate bonds, common stocks and some longer-term Treasuries), frictional transaction costs (especially in over-the-counter secondary markets) and outright illiquidity (in most alternative assets) are common. These risks don’t apply only to investors’ need for liquidity to settle external obligations; they also apply to internal liquidity requirements related to portfolio rebalancing and capital calls.

Given the higher costs and operational barriers to accessing capital on short notice from the broader portfolio, investors may want to consider creating or expanding a dedicated liquidity strategy that seeks to pre-fund a more significant portion of their upcoming obligations using actively managed ETFs. By doing so, they can eliminate operational risks and the potential costs associated with obtaining liquidity in the future. Although the current inversion of the yield curve makes this approach economically attractive, even when this unusual benefit fades at some future point, the strategic and operational advantages should remain.

More than cash: Structuring a liquidity pool

To date, investors have primarily relied on one of two methods to build out a more comprehensive liquidity strategy: using either a customized bond portfolio structured to match cash flows or employing a sequence of targeted fixed income strategies that progress from shorter to longer duration. Understanding the trade-offs of each approach is important because the amount of capital available for liquidity management is limited—and efficiency is essential. Significant differences exist between these options with respect to their complexity, cost and return potential.

In our view, the best solution is actually a sequence of highly liquid, actively managed fixed income ETFs that collectively provide the best of both worlds: the low risk and cost associated with laddered bonds and the diversification and return potential of actively managed strategies. This approach is also simple to design and implement, can be structured to align with investors’ liability characteristics and—with active management—can respond to changing market conditions.

The pros and cons of hedging near-term obligations

In our experience, investors rarely “ring-fence” sufficient capital to cover more than a few quarters or years of upcoming obligations. Exhibit 1 shows five years of quarterly cash flows, along with visual representations of the two methods described above. Five years is somewhat arbitrary: For a given investor, the chosen liabilities could easily be shorter (or longer). Five years probably represents the most reasonable time limit for a dedicated liquidity sleeve, however, as anything more extensive would draw in too much capital that could be invested more productively elsewhere.

Cash flow matching with a bond ladder

One approach to managing future liquidity needs has been to pre-fund near-term obligations with a laddered portfolio of high quality fixed income securities. Future liquidity needs are directly offset by a bond maturing at the same time, delivering liquidity at no cost. The concept has clear appeal: Extending maturities from cash to longer-maturity instruments generally increases return, and liquidity is contractually guaranteed at maturity, so transaction costs are limited to the initial purchase. 

Such cash flow matching strategies face several real-world challenges, however, that often make them less efficient than expected (or desired):

• Choosing bonds based on their specific maturity date—rather than their attractiveness as investments—implicitly assumes that avoiding future transaction costs is more valuable than generating positive performance over time. 
• Such strategies may actually lock in negative performance relative to liabilities, as they select only the highest quality—and lowest yielding—securities to avoid credit risk. By their nature, these buy-and-hold strategies are unable to profit from manager skill in security selection.
• The strategy works best when investors have precise knowledge of their future obligations. However, as liabilities extend into the future, they tend to become less quantifiable with respect to timing and/or size.
• Targeting asset maturity dates precisely makes little sense if the liabilities are uncertain. Without the promise of close alignment, the strategy’s efficiency dissipates—bonds may mature before the cash is needed, reducing yield, or after the cash is required.

The net result is that a laddered strategy, in seeking precise alignment with liabilities, substitutes one risk for another. The risk of being forced into making potentially costly sales on the secondary market diminishes, but the danger of the strategy underperforming baseline return targets increases. This may be something of a false choice, however, because investors can capture most of the benefits of a ladder without sacrificing valuable returns if they use highly liquid ETFs instead.

ETF sequencing strategies

A better option may be structuring a sequential group of highly liquid ETFs that collectively provide the best attributes of laddered strategies while avoiding their complexity and low returns. Simple to design and implement, these strategies can be closely aligned with investors’ liability characteristics, actively managed to optimize yield and credit risk, and they offer access to liquidity in real time (and at lower cost) than other, more traditional options.

The benefits of ETF sequencing can be significant:

• Payments can be readily aligned with maturities: Lining up various short-term and intermediate-duration fixed income ETFs against liability cash flows of similar maturity is quite straightforward. In Exhibit 1’s five-year liability example, an ultra-short ETF is used to pre-fund the first 18 months (six quarters) of liability; a short-duration core-plus ETF funds the subsequent 24 months (eight quarters); and a core-plus ETF is aligned against the final 18 months (six quarters).
• As maturities increase, so does the flexibility of active management: The ultra-short ETF, which ultimately warehouses the cash used by the investor for meeting obligations, has the most conservative guidelines, the lowest possible drawdown risk and the most liquid and efficient secondary market. The longer strategies take on slightly more risk across the underlying portfolios, allowing the strategies to generate higher levels of yield and return. Across the full sequence, performance should exceed reasonable measures of the liability hurdle rate.
• Liquidity comes at a lower cost: An ETF vehicle is ideal for this use case because it offers liquidity at a much lower cost than the portfolio’s underlying bonds. This is particularly important for the ultra-short pool, which bears responsibility for payments as they come due and receives top-up inflows afterward. But all three components will benefit from low cost liquidity at the time of initial funding as well as during any subsequent rebalancing.
• Active improves on passive: Common benchmark-driven strategies at the shorter end of the maturity spectrum focus on the highest quality assets, such as Treasury bills, and miss out on the diversification and return enhancement that an active manager can provide.

Exhibit 2 describes the relationship between the various approaches in terms of return potential and cost efficiency. Holding pure cash may involve no risk whatsoever, but it also offers the lowest level of return (at least in a normal yield curve environment). A bond ladder offers higher return with very little risk, but it remains unlikely to deliver a return above the rate applied to the liabilities themselves. The benefits of fund sequencing are likely to be optimal for investors because the strategy offers a higher potential return—and greater transactional efficiency—than either a traditional bond portfolio or the broader asset allocation.

The yield advantages of active fixed income strategies

Just because other assets carry the burden of generating returns does not mean that the liquidity pool is absolved of the responsibility to be managed as efficiently as possible. Indeed, the ability to generate returns in excess of cash and in excess of the implied rate of return on liabilities becomes more important as the liquidity pool grows. While there is no single rate that can be applied across different investors’ liabilities, we can make the reasonable assumption that short-term fixed obligations should be discounted at a conservative rate.

Helpfully, the Internal Revenue Service (IRS) publishes monthly a table of A–AAA corporate bond yields across the full maturity spectrum for use as a discount curve for pension liabilities. In this analysis, we repurpose three of these rates—the one-year, three-year and five-year—as baseline target yields for liquidity sleeves of similar durations. Our operating assumption is that a liquidity vehicle should offer a yield at least as high as these rates across time.¹

The analysis below supports the idea that a fund sequence using some combination of ultra-short, short core-plus and/or core-plus bond strategies may offer yields in excess of future liabilities. In each case, virtually identical strategies are available as active mutual funds or active ETFs (Exhibit 3). In this analysis, we have elected to use mutual fund yields, since they allow us to illustrate a longer history (Exhibits 4A, 4B and 4C).

Allocation advantages of liquidity management

Liquidity strategies are constrained by their generally low returns vs. investors’ strategic objectives. But low absolute returns are only part of the calculus involved in fully considering their value within a broader asset allocation. Judging the value of the liquidity portfolio based only on the magnitude of its return drag vs. other assets is flawed.

To the extent that the remainder of the allocation may generate sufficiently high returns, the return drag from the liquidity pool can be offset elsewhere. Importantly, these efforts can be complementary: By locking in liquidity to cover multiple quarters or years of obligations, investors can tolerate higher levels of volatility and/or illiquidity elsewhere in their asset allocation. The net result may well be a higher overall level of return, along with a greater margin of operational safety than a portfolio that shuns cash in favor of volatile public markets while limiting illiquid investments.

Exhibit 5 offers a stylized example that helps to illustrate this concept. It begins with a simplified opportunity set of common asset classes, including private alternatives, public equity, public fixed income and cash, along with corresponding illustrative returns for each.

We then draw a comparison between two allocation models:

• First, a traditional return-seeking strategy with 50% in public equity, 30% in public bonds and 20% in private alternatives. This model portfolio holds no cash, instead relying on its public market assets for ongoing liquidity.
• Second, a strategy that shifts 10% to cash and reallocates an additional 15% from public market stocks and bonds to private alternatives. 

To err on the side of being conservative in the example below, we make no effort to enhance the returns on the cash portfolio. Furthermore, we do not propose a strategy that uses the cash allocation as a collateral pool for index derivatives.

One stylized example does not tell the whole story, but the basic premise is clear: The allocation with a dedicated liquidity pool may be capable of delivering higher returns because the structured liquidity supports a larger exposure to private alternatives. Is it riskier? Probably not. If the 10% in cash offsets obligations over several quarters or years, the risk of a liquidity shortfall is effectively eliminated. In the event that the cash pool is unexpectedly depleted, a further 55% in public market assets are available to serve as a backstop.

Conclusion

Asset allocators have long disdained holding cash as a costly drag on portfolio performance—a stance that many are having to reconsider in the current yield curve environment. But investors’ increased willingness to add portfolio exposure to high quality liquid assets may lead to a more fundamental discussion of the role of cash—or, more correctly, liquidity programs—in diversified asset allocations. Liquidity constraints often act as a barrier to deploying capital in more volatile or more illiquid sectors that may offer higher returns and/or greater diversification. The use of a liquidity pool that effectively pre-funds near-term obligations may remove these constraints and lead to more efficient strategies.

¹ For this analysis, we look at the yield differential rather than historical total returns. A high quality, short-duration portfolio (or liability) is likely to experience returns that are quite close to the initial yield at the time of purchase. Furthermore, since the durations of assets and liabilities are closely aligned, movements in interest rates—the single most important underlying risk factor—will impact both to a similar degree.