Message in Focus

Put cash to work

In a world of negative real rates, cash is an increasing drag on returns.

At a glance

Cash is often referred to as a risk-free asset and a store of value. But it has a poor track record of holding value over the long term. With nominal interest rates currently lower than inflation, real rates are negative, increasing the drag from cash. Once investors have sufficient liquidity to meet up to five years of spending needs in excess of income, we recommend focusing on long-term returns by seeking yield and growth.

Short- and long-term strategies to put cash to work

Markets are pricing the ECB deposit rate to trade below zero for years, with Swiss policy rates expected to be even lower than ECB rates. Assuming any inflation, real rates will remain even lower. What’s more, negative central bank interest rates are filtering through the financial system, and it looks probable that more banks will pass on the cost to depositors. All this means that the purchasing power of cash will be eroded over time, as the cost of goods and services rise faster than the income earned on cash holdings.

We believe investors need to re-think the role of cash in their portfolios. Around 62% of investors surveyed in our Investor Sentiment survey hold more than 10% in cash and equivalents. Cash will continue to be of use to meet immediate expenses. But for investments earmarked to meet longer-term spending needs, the short-term safe-haven qualities of cash become a liability because they reduce potential investment returns.

Around 62% of investors hold more than 10% in cash and equivalents.

Source: 1Q21 UBS Investor Sentiment survey

Why is cash bad?

The downsides to cash have recently been underlined by rising inflation – even though we expect this to be short-lived. US consumer prices rose 4.2% in the year to April, the fastest pace since 2008.At current interest rates, holding excess cash reduces your wealth as inflation erodes its real purchasing power. Take the example of an investor with a USD 5 million portfolio and an annual expense of USD 250,000 that is rising by 2% each year due to inflation. Keeping the portfolio in cash would halve its value in just 10 years. Any further uptick in inflation would increase the erosion of real purchasing power. This is a problem for US, European, and Swiss investors where real rates are all negative. According to UBS Evidence Lab, 49% of family offices see low interest rates posing a major challenge to performance in the next three to five years. Accordingly, they plan to dial down strategic asset allocation to low yielding bonds and cash.

How much cash do you need?

Professional investors typically keep very low cash balances. The seven biggest pension fund nations globally, which had total assets over USD 42,771bn in 2019, have an average of just 4% cash exposure, while holding around 45% in equities. While private investors may need more than this, especially as they near or enter retirement, we believe many hold too much cash. Our Investor Sentiment survey showed that investors have actually started to reduce their cash holdings by 3% since Sep 2020 to 22%. We recommend investors hold only enough liquidity to meet cash flow needs in excess of spending for up to five years, and not all of this liquidity needs to be held in deposits.

Investors have actually started to reduce their cash holdings by 3% since September 2020 to 22%.

Source: 1Q21 UBS Investor Sentiment survey

How should I invest instead?

Having set aside enough liquidity for upcoming needs, we believe investors should focus on finding yield and growth opportunities, especially in equities where we see greater return potential than in broad credit markets. The average annual return on the MSCI All Country World index since 1998 has been 8% (USD total return), meaning investors over this period have doubled their money roughly every 10 years. Risks from such asset classes can be reduced by investing in a balanced portfolio of stocks, credit, and high quality bonds. Meanwhile, those concerned by the threat of poor market timing can consider alternative market entry strategies, establishing a schedule for averaging into risk assets or using put-writing strategies to take advantage of dip-buying opportunities. But historical data suggests that putting capital to work straight away produces higher long-term returns.

So, while cash holdings are necessary, excessive cash creates a drag on returns. We believe investors should consider their liquidity in three main tiers: Tier I is for everyday cash needs in the coming 6-12 months; Tier II is savings cash for known needs over the coming two years; and Tier III is investment cash to meet potential investment opportunities over the coming 2-5 years. The first two tiers in our view should be mostly held in cash deposits, and investors who can consider taking on more credit, market, or counterparty risk have the potential to earn higher returns in Tier III, for instance by investing in a well-diversified bond portfolio or yield-focused structured solutions with terms that include principal protection. One such strategy for investors looking to generate a return pick-up versus short-term bonds while maintaining capital preservation is to consider market-linked certificates of deposit (MLCDs). We estimate that 5-year MLCDs could offer around twice the expected return of 5-year Treasuries, in return for investors locking up their capital and accepting some return uncertainty.

Investors should also consider setting aside borrowing capacity—for example, a securities-backed credit line—to fund a portion of their Liquidity strategy. This can reduce the potential drag on returns that comes from holding cash and high-quality bonds.

Beyond this, we recommend investors put their cash to work beyond their Liquidity strategy and into funding their Longevity and Legacy strategies, in strategies that are geared for greater long-term growth potential such as balanced portfolios or equity markets.

Key investment takeaways:

Negative real rates increase the drag on returns from cash, and this could get worse if inflation moves higher.
Once investors have sufficient liquidity to meet up to five years of spending needs in excess of income, we recommend focusing on long-term returns by seeking yield and growth.
This can be achieved by investing in credit and equity markets. Meanwhile the drag from liquidity holdings can be reduced, particularly for funds required for more distant spending needs, by considering riskier investments – such as diversified bond portfolios or structured solutions.

Investing in structured investments involves significant risks. For a detailed discussion of the risks involved in investing in any particular structured investment, you must read the relevant offering materials for that investment. Structured investments are unsecured obligations of a particular issuer with returns linked to the performance of an underlying asset. Depending on the terms of the investment, investors could lose all or a substantial portion of their investment based on the performance of the underlying asset. Investors could also lose their entire investment if the issuer becomes insolvent. UBS Financial Services Inc. does not guarantee in any way the obligations or the financial condition of any issuer or the accuracy of any financial information provided by any issuer. Structured investments are not traditional investments and investing in a structured investment is not equivalent to investing directly in the underlying asset. Structured investments may have limited or no liquidity, and investors should be prepared to hold their investment to maturity. The return of structured investments may be limited by a maximum gain, participation rate or other feature. Structured investments may include call features and, if a structured investment is called early, investors would not earn any further return and may not be able to reinvest in similar investments with similar terms. Structured investments include costs and fees which are generally embedded in the price of the investment. The tax treatment of a structured investment may be complex and may differ from a direct investment in the underlying asset. UBS Financial Services Inc. and its employees do not provide tax advice. Investors should consult their own tax advisor about their own tax situation before investing in any securities.

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Put cash to work

At a glance

Short- and long-term strategies to put cash to work

Key investment takeaways:

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