Cash holdings in investment portfolios are at record highs, and the rationales for these allocations are remarkably diverse. Some investors seek to wait out market volatility, while others have strategically increased cash allocations to reduce portfolio risk. Many are “barbelling” higher-yielding, volatile core assets with lower-volatility, income-producing short-term fixed income strategies. Still others are seeking to optimize returns on cash before U.S. money market reform takes effect later this year.

At the same time, two profound market dynamics are at play: First, 2a-7 money market funds continue to yield next to nothing due to a multitude of influences, including supply constraints, more demand and the forthcoming regulatory reforms; second, investors ‒ ranging from individuals to large institutions ‒ are increasingly deploying ETFs in their investment portfolios due to their transparency and operational ease of use.

The question many investors are asking now is how can ETFs be used for liquidity and volatility management given these evolutionary market changes? Here are some of the important considerations and why PIMCO’s actively managed short-term ETFs, MINT and LDUR, may be superior tools for liquidity management.

‘Capital preservation’ does not necessarily maintain purchasing power

In today’s environment, many investors are seeking “safety” by allocating to money market funds, which are expected to return capital because of their stable net asset value (NAV). Similarly, many ETF investors have chosen U.S. Treasury-bill funds both for their low total expense ratios and the perceived safety of index T-bill exposure.

However, preserving capital does not equal preserving purchasing power ‒ essentially, returns after inflation. Figure 1 looks at the decline in purchasing power of T-bill index returns in the low inflation environment since the financial crisis of 2008. The same holds for money market funds: For much of the past 40 years, traditional money market funds have provided investors with positive inflation-adjusted returns, but in today’s low yield environment, that is no longer the case. In more normalized, higher-inflation environments, the erosion of purchasing power could be even greater.

Active short-term management strategies can potentially remedy this deficit because they seek not only return of nominal capital but also additional income, which can help protect purchasing power. When considering cash strategy alternatives, liquidity and capital preservation are important, but they are not the only considerations. It is also important to look at the risk, or volatility, for a given level of return. One measure of this is the Sharpe ratio, which is calculated by taking the average return earned in excess of the “risk-free” rate, typically represented by T-bill returns. The greater the Sharpe ratio, the more attractive the risk-adjusted return.

Figure 2 shows the returns, volatility and Sharpe ratios of the PIMCO Enhanced Short-Maturity Active ETF (ticker: MINT) and the PIMCO Low Duration Active ETF (ticker: LDUR), along with those of the Citi 3-Month Treasury Bill Index and the Bank of America Merrill Lynch 1-3 year U.S. Treasury Index.

The data in Figure 2 illustrate important issues. First, for investors seeking capital preservation, ETFs that track T-bill and even short maturity indexes may not adequately compensate investors for the risks they take, even though they may be low-cost. Second, the after-fee, risk-adjusted returns of active ETFs may better protect purchasing power.

Getting active, going global and diversifying to reduce volatility and improve liquidity

Short maturity active ETFs can employ several levers for helping reduce risks and enhance returns. Active management generally increases an ETF manager’s freedom to navigate volatile markets. Namely, active managers can utilize a wide opportunity set:

  • Multiple sectors, and the ability to adjust exposures as market conditions and manager views change, offer key advantages. Most index ETFs used for liquidity management provide exposure to one or two sectors of the market, such as Treasuries or investment grade credit, and usually only the U.S. bond market. They maintain a static, structural exposure to interest rates (duration), which can potentially result in lower performance as rate expectations adjust. Unlike active ETFs, index funds only adjust exposures when the index changes. This leads to forced “buying and holding,” as well as forced selling when market conditions might warrant just the opposite.
  • A global opportunity set. Of the roughly $100 trillion in global bonds, the U.S. market represents only about one-third of the existing inventory and U.S. T-bills less than 2% of the total, or about $1.6 trillion. T-bills outstanding have declined by about $600 billion since the financial crisis, yet new requirements under money market reform are leading many asset managers to create government-only funds, further reducing supply of T-bills.
  • Alternative weightings and out-of-index securities. The largest bond index ETFs are market-capitalization weighted: They base the size of their exposure to any given security on how much is outstanding relative to other securities. Thus, index ETFs have the largest exposures to the most indebted borrowers or sectors. They also have limited ability to hold securities that are not in the index (typically 20% of the fund), which can potentially limit their diversification.

As one of the biggest and most experienced bond managers, PIMCO is positioned to take advantage of these levers. The short-term and funding desk at PIMCO manages about $300 billion in cash and short duration strategies globally, including MINT, the largest actively managed ETF, and LDUR, which represents an additional step out on the risk/return spectrum. The short-term desk draws on PIMCO’s time-tested investment process, including the firm’s top-down macroeconomic outlook and bottom-up sector and security selection from over 50 credit analysts worldwide. This is an experienced team of more than 10 portfolio managers who have managed cash and liquidity globally through many market cycles and macroeconomic environments, including the challenges of 2008. The team most recently won Morningstar’s U.S. Fixed Income Fund Manager of the Year award for 2015.

Implementing an ETF as an alternative to cash solution

Consider the holding period

When thinking about how to strategically manage cash and portfolio liquidity, the important considerations are how much cash is needed? What is the purpose of the cash holding (which drives the likely holding period and the risk tolerance)? And finally, what are the risk and return characteristics of potential cash and alternative cash solutions?

Consider, for example, a financial advisor who is helping a client and has identified three possible cash needs: a reserve to cover six months of household expenses, the purchase of a new car in one year, and the down payment for a home in two to three years. The client has a moderate risk tolerance, and the timing of the car and the home purchases could be pushed back.

How might this investor think about managing cash?

Tier cash to maximize return potential for given risk tolerance

A potential solution is to tier the allocation into cash and alternative cash investments using money market funds and active short-term ETFs such as MINT and LDUR. Money market funds* may be well suited to immediate cash needs, while cash alternatives like MINT could be considered for holding periods in excess of three months. MINT seeks to provide a stable, although not constant dollar, NAV and additional income in the form of monthly distributions and has been used extensively for liquidity management. LDUR can be added to a tiered liquidity portfolio and used to help grow portfolio balances over a longer time horizon, generally more than a year; LDUR has core bond characteristics and thus an incrementally higher risk/return profile than MINT.

In the example above, the funds needed to buy a home could be invested in LDUR while those needed for a new car as well as a portion of the reserve for household expenses could be invested in MINT. The balance of the reserve for expenses would likely need to be in a money market fund. The relative size of these three investments could be adjusted as the time approaches for purchasing the car and the home. In other words, the portfolio can be rebalanced between these three investments, bringing the overall portfolio down to a lower risk/return target as the need for cash becomes more immediate.

Figure 3 illustrates cash tiering by risk tolerance, showing the change in allocation as holding periods decrease.

Tiering cash attempts to better align the risk and return characteristics of cash and alternative cash assets with the holding period and risk tolerance of investors to preserve purchasing power and enhance risk-adjusted return.

*Money market funds are not insured or guaranteed by FDIC or any other government agency and although such funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in money market funds.

The Author

Jerome M. Schneider

Head of Short-Term Portfolio Management

Natalie Zahradnik

ETF Strategist

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Disclosures

Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the Fund’s prospectus, which may be obtained by contacting your PIMCO representative. Please read the prospectus carefully before you invest.

The “risk-free” rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value.

The allocation scenarios discussed herein are not based on any particularized financial situation, or need, and are not intended to be, and should not be construed as, a forecast, research, investment advice or a recommendation for any specific PIMCO or other strategy, product or service. Individuals should consult with their own financial advisors to determine the most appropriate allocations for their financial situation, including their investment objectives, time frame, risk tolerance, savings and other investments. Volatility is historical and is likely to change over time. Other fixed income allocations may be less volatile. Fixed income is only one possible portion of an investor’s portfolio, which can also include equities and other products. Investors should speak to their financial advisors regarding the investment mix that may be right for them based on their financial situation and investment objectives.

The Morningstar Fixed Income Fund Manager of the Year (2015) award is based on the strength of the manager, performance, strategy, and firm’s stewardship.

The performance figures presented reflect the total return performance for fund type or fund share classes stated. These figures reflect changes in share price, reinvestment of dividends, and capital gain distributions. All periods longer than one year are annualized.

A word about risk: Investing in the bond market is subject to certain risks including the risk that fixed income securities will decline in value because of changes in interest rates; the risk that fund shares could trade at prices other than the net asset value; and the risk that the manager’s investment decisions might not produce the desired results. Investments may be worth more or less than the original cost when redeemed. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Diversification does not ensure against loss

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The NAV of the fund’s shares is determined by dividing the total value of the fund’s portfolio investments and other assets, less any liabilities, by the total number of shares outstanding. Fund shares are valued as of the close of regular trading (normally 4:00 p.m., Eastern time) (the “NYSE Close”) on each business day. The price used to calculate market returns (Market Price) of the Fund generally is determined using the midpoint between the highest bid and the lowest offer on the national securities exchange on which shares of the fund will be primarily listed for trading, as of the time that the fund’s NAV is calculated. The fund’s Market Price may be at, above or below its NAV. The NAV of the fund will fluctuate with changes in the market value of its portfolio holdings. The Market Price of the fund will fluctuate in accordance with changes in its NAV, as well as market supply and demand.

Premiums (when market price is above NAV) or discounts (when market price is below NAV) reflect the differences (expressed as a percentage) between the NAV and the Market Price of the Fund on a given day, generally at the time the NAV is calculated. A discount or premium could be significant. Data in chart format displaying the frequency distribution of discounts and premiums of the Market Price against the NAV can be found for each Fund at www.pimcoetfs.com.Buying or selling ETF shares on an exchange may require the payment of brokerage commissions. Due to the costs inherent in buying or selling Fund shares, frequent trading may detract significantly from investment returns. Investment in Fund shares may not be advisable for investors who expect to engage in frequent trading.

ETFs are subject to secondary market trading risks. Shares of an ETF will be listed for trading on an exchange, however, there can be no guarantee that an active trading market for such shares will develop or continue. There can be no guarantee that an ETF’s exchange listing or ability to trade its shares will continue or remain unchanged. Shares of an ETF may trade on an exchange at prices at, above or below their most recent NAV. The per share NAV of an ETF is calculated at the end of each business day, and fluctuates with changes in the market value of the Fund’s holdings. The trading prices of an ETF’s shares fluctuate continuously throughout the trading day based on market supply and demand, which may not correlate to NAV. The trading prices of an ETF’s shares may differ significantly from NAV during periods of market volatility, which may, among other factors, lead to the Fund’s shares trading at a premium or discount to NAV.

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