This is a topic I've been thinking about for myself and my parents as I've been exposed to a lot of regulatory information recently. I thought it might help others for me to put it down on digital paper. Note that it's targeted at individuals who are more conservative in their investments and have substantial balances. Many Mustachians will have more aggressive allocations so may not get as much value out of it. Any feedback is appreciated and I may edit the post based on that feedback.
Roll your own cash fund - why you should consider managing your own defensive assets
In this post I outline why it may be beneficial for conservative investors with fairly substantial savings to manage their own defensive assets in cash, rather than use a Cash or Fixed Interest allocation in Super. This is not intended as advice, just some insights from institutional asset management. Note that I work for an industry super fund so at the margin it could be argued that I benefit from people doing the opposite of this advice.
We regularly hear SMSFs have too much cash. And there are probably many cases where those statements are right. Historically government bonds have provided better returns. But there are good reasons, if you want to lean more towards defensive assets, why managing more of your own cash can be the best choice available at the moment.
Why Cash rather than a Bond or Fixed Interest option?
If you are a more conservative investor (less than 50% in growth/risky assets such as shares and property) in these days of low interest rates you need to eke out the highest expected returns from your defensive assets you can. One alternative is to take more risk but for many conservative investors that has psychological costs or invites sequence of returns risk (where a bad equity market just before or just after retirement can derail your plans).
So that begs the question, what are expected returns of Cash and Bonds. Ignoring fees, etc. at time of writing:
Good online savings accounts outside super yield 2.87-3.0% p.a. (e.g. UBank, ING, Rams)
Good Term Deposits inside or outside super yield around 2.5 - 2.8% p.a.
AusBond Composite 0+ Bond Index YTM 2.27% p.a.
AusBond Treasury 0+ Bond Index YTM 2.13% p.a.
The Yield to Maturity (YTM) from the iShares website is a good estimate of the expected return of a broad bond index that doesn't have much credit risk, as is the case with these standard Australian bond indices (Composite 0+ does include about 10% Corporate Bonds which accounts for the higher yield and shorter duration). The actual return will be higher when interest rates fall and lower when interest rates rise (interest rate risk, which can be measured by duration). Where, historically in many countries, bonds have outperformed cash we can see good estimates today suggest they can only do so today if intermediate to long-term interest rates fall.
If your portfolio (super, outside investments and savings) are invested more in equities, property and other growth assets you might invest more in bonds for the diversification, in the expectation that when shares fall bonds will get better returns. We saw that happen in 2008 but not in 1994, so there are no guarantees. But if you are running a more conservative portfolio then these potential correlation benefits are likely to be outweighed by differences in expected return.
Why invest Cash yourself rather than the Cash investment option of your Super Fund
In equities, bonds, commercial property, infrastructure and alternative assets I see big drawbacks in DIY. If you're index investing, the large funds can get much cheaper rates. If you're active, large funds can not only get cheaper rates but access to better managers. So why would I suggest investing cash yourself?
The key reason is bank regulation. In current and upcoming regulation (LCR and NSFR for example, if you want to Google for more information) banks are incentivised to have more of their liabilities either in long-term funding or 'retail' funding, that is funding from individuals. Funding from financial institutions, which includes all large super funds, is penalised.
The bottom line of this is that banks can (and do) offer better rates to individuals than to large super funds. And the difference is large, with term deposits of 3 - 6 months I see offered to super funds more like 2.0-2.3%, around 0.5% lower than an individual could get even before fees. When rates have a 2 in front of them that's a very big difference.
How would I invest like this?
I can't give advice but will give a couple of examples that relate to me personally. In my case, my plan for defensive assets is to either to:
i) hold cash in an offset account while I have a mortgage
ii) once my mortgage is paid off, use online savings accounts
This sort of cash has the advantage of being extremely flexible in that I can use it for emergencies also and it has no fees. Of course with ii) above I'll pay taxes at my marginal rate whereas in Super I would pay a lower tax rate. So while I'm working, even with the higher rate, it's very close to the expected return I'd get from Cash or Bonds in Super after tax.
For my parents, they have most of their financial assets in Super so the availability of good ongoing high-interest savings accounts is more limited but they pay zero taxes in retirement. They run a much more conservative asset allocation also. In their case I will be suggesting the direct investing option of their super fund so long as those term deposits continue to be treated by regulators as retail money and so gets retail rates.
One of my parents is with NGS Super (they have been for a long time so I'm using them as an example, not a recommendation). NGS charge an extra $247 p.a. to invest in individual shares, ETFs and Term Deposits (they have four different banks available, although one of them has particularly poor rates). In my parents' case they have a big enough balance that it's worth it to use just for TDs (for example, if you had $247,000 then $247 p.a. amounts to 0.1% p.a in addition to their base admin fees of $65 + 0.1% p.a.).
So what we'll likely do is use the transaction account and term deposits to build a ladder of term deposits. That is, instead of having a single 3Month or 6M term deposit with one or more banks, invest each month so that a term deposit is maturing every month. A simple example:
At the start invest 1/3rd in a 3M term deposit and 2/3 in cash or a 1M term deposit
After 1 month, invest another 1/3rd in a 3M term deposit and the remaining 1/3rd in cash or a 1M term deposit
After another month invest in another 3M term deposit.
Then every month invest the maturing money in a new 3M term deposit
At current rates you'd have a ladder paying 2.4-2.7% p.a. depending on the bank.
The advantage of the ladder is that a term deposit matures every month so you get around the illiquidity if you need to access the money early (in retirement) or make an asset allocation change.
Obviously you could spread this out if you wanted a 6 Month or longer ladder as well/instead, or you could invest smaller amounts weekly if you wanted to improve liquidity further (but with additional work as you'll have to either set them to auto roll-over or be reinvesting a term deposit every week).
Similarly if you had an SMSF you could build a ladder of Term Deposits (although using multiple banks would require a fair bit more paperwork in that case). If you stay within limits for each bank, SMSF cash can also be government guaranteed.
Note that even in my parents' case we'll be keeping some fixed income in bonds, partly for diversification (I could be wrong!) and partly because it is not worthwhile financially in their other fund given their particular asset allocation.
Why would I not invest like this?
- If you had a higher allocation to growth assets, as mentioned above, you might see more diversification benefit from longer-term bonds if shares fall in a crisis and you are willing to rebalance regularly when this happens
- If you have a smaller balance in defensive assets (10s rather than 100s of thousands) the fixed admin costs swamp the difference in interest rates
- If you are a nervous investor who looks at their investments individually and seeing larger fluctuations in the non-defensive parts of your portfolio whenever you log in to roll a term deposit would stop you sleeping well at night. In this case an all-in-one "Conservative" option is probably better for your sanity