Your Brokerage Cash Probably Earns Only .01%
The dirty little secret isn’t so secret anymore. Over the past few years, most brokerage firms quietly eliminated the option of sweeping uninvested cash into a money market fund. Instead, nearly all brokers now sweep cash into an affiliated bank account. The good news is that bank accounts are FDIC insured. The bad news is that the yield on virtually all of these accounts is .01%.
That’s right: .01%. According to a May 6 Crane Data article:
“Our Crane Brokerage Sweep Index, the average rate for brokerage sweep clients …[has] hit the floor at 0.01%. All of the major brokerages now offer rates of 0.01%. No brokerage sweep rate or money fund yield has dropped to zero or gone negative to date, but this could become a distinct possibility in the coming weeks or months. Crane's Brokerage Sweep Index has been flat for the last four weeks at 0.01% (for balances of $100K). Ameriprise, E*Trade, Fidelity, Merrill Lynch, Morgan Stanley, Raymond James, RW Baird, Schwab, TD Ameritrade, UBS and Wells Fargo all currently have rates of 0.01% for balances at the $100K tier level (and almost every other tier too).”
The bank fees and interest rate spread that brokers earn on client sweep accounts is one of the major reasons why they are able to offer free trading. A recent Barron’s article cites Schwab as an example: “The firm is partly a discount broker and asset manager, and partly a federally regulated bank (through its Schwab Bank subsidiary). Schwab makes most of its money off interest income from reinvesting customer cash and other assets.”
What’s an investor to do?
An Ultra-Short ETF May Be Your Best Option
Brokers make it easy, and often the default, to sweep your cash into a bank account. If you want to invest it in a money market mutual fund to get a higher yield, you can usually do that, but operationally using a money market mutual fund (MMF) for managing cash can be difficult. Let’s say you decide that you want to make an investment in a stock or an ETF (exchange-traded fund) and you need to sell some of the MMF to fund the investment. You will need to sell the MMF and then wait at least one day (and maybe two days) before you can make your purchase in order for the cash from the sale to be collected funds in your brokerage account.
However, since an ETF trades during the day just like a stock, assuming that your brokerage account allows simultaneous purchases and sales of ETFs (most margin accounts do this), you will be able to sell an ETF and immediately invest the proceeds of the sale into something else. That’s why using an ETF to invest your idle cash may be your best option.
However, technically, there are no money market ETFs. Money market mutual funds have a constant price of $1 and no price fluctuation whatsoever (that is, unless they "break the buck," which is a disaster for them). Instead, there are a number of "ultra-short term bond ETFs" that have only a small amount of price variability, but which often have higher yields than MMFs.
Investopedia defines an ultra-short bond fund as one that “invests only in fixed-income instruments with very short-term maturities. An ultra-short bond fund will ideally invest in instruments with maturities around one year. This investing strategy tends to offer higher yields than money market instruments, with fewer price fluctuations than a typical short-term fund.” Usually, the duration of an ultra-short bond fund will be 1 or lower. (Duration measures the sensitivity of a bond or fund to changes in interest rates. A duration of 1 indicates that if interest rates were to move up by .5%, the bond or fund would decline by .5%.)
Below is a table of all ultra-short ETFs that meet the following two criteria:
- Expense ratio of .20% or below
- Bid-ask spread of .10% or below
Ultra-short bond funds tend to fall into two categories:
- Treasury funds (that invest at least 80% in government bonds, usually Treasury securities)
- Corporate funds (that invest at least 80% in corporate debt, usually bonds or bank loans)
The best way to compare the expected return among ultra-short bond funds is to use the 30-day SEC yield. According to Investopedia, this yield "is based on the most recent 30-day period covered by the fund's filings with the SEC. The yield figure reflects the dividends and interest earned during the period after the deduction of the fund's expenses.” The graphs below use “net yield” which is the SEC yield minus the bid-ask spread. As shown below, the yields of the Treasury funds are much lower than those of the corporate funds, and some are even negative.
In addition to the 15 ultra-short bond ETFs that meet the criteria, the table above also includes two Vanguard mutual funds for comparison purposes:
- Vanguard Money Market Reserves Prime Fund (VMRXX) – to represent money market mutual funds
- Vanguard Ultra-Short-Term Bond Fund (VUSFX) – to represent ultra-short term bond mutual funds
For the operation reasons explained above, it is much more cumbersome to use a mutual fund to invest cash in a brokerage account than an ETF. Consequently, we will focus on ETFs.
The graph above makes clear that the yield/duration tradeoffs of Treasury ultra-short ETFs (green dots) are relatively unattractive compared to the corporate funds (blue dots). Consequently, we will focus on corporate ultra-short bond ETFs.
The two floating-rate funds, FLOT and FLRN, look particularly attractive from a yield/duration standpoint. However, not so fast. There are two major kinds of risk in a bond fund:
- Interest rate risk, as measured by duration
- Credit risk, which is not as easily summarized
However, because credit risk is related to many of the same risks that drive stock market returns, one way to measure credit risk in a bond fund is with “market beta”—the statistical sensitivity of the returns of the fund to stock market returns. At Sapient Investments, we use four broad risk factors to measure and control those risks that tend to explain the majority of the returns for ETFs:
Risk Factor Risk Description Risk Index
MKT Stock market risk S&P 500
LTB Bond market risk 10 Yr. Treasury
DLR Currency risk US Dollar
OIL Commodity risk WTI Crude Oil
We measure the sensitivity of each ETF to these four risk factors simultaneously using exponentially-weighted multiple regression analysis over 36 months. When analyzing bond funds, it is important to use a multiple regression to separate the effects of market risk (MKT) from interest rate risk (LTB). Exponentially weighting the historical returns helps to make the sensitivity estimates more dynamic and forward-looking.
The graph below uses the same net yield as above but introduces S&P 500 beta as a way of estimating a bond fund’s level of credit risk. For comparison purposes, two other bond ETFs are included (in orange):
- iShares Core US Aggregate Bond ETF (AGG) – to represent the overall U.S. bond market
- Highland iBoxx Senior Loan ETF (SNLN) – to represent bank loan bond funds
The reason for including SNLN is to highlight the fact that the two floating rate funds, FLOT and FLRN, include a large number of floating rate bank loans among their assets. This gives them a high level of credit risk.
It may be surprising that the overall bond market, as represented by AGG, has a low enough level of credit risk to be down near the credit risk level of ultra-short corporate bond funds. The explanation has to do with the large percentage of Treasury and agency bonds within the AGG portfolio. Government bonds constitute 59.4% of the total holdings in AGG, and because government bonds tend to have a negative MKT beta, they largely negate the credit exposure of the corporate bond contingent within AGG.
Still, FLOT and FLRN have a relatively high level of MKT beta, and therefore credit risk—not quite as high as SNLN, but tending in that direction. A linear combination of cash (zero in both yield and credit risk) and SNLN would clearly dominate FLOT and FLRN. In fact, most of the ultra-short funds are dominated by such a combination.
Recommended ETF: iShares Ultra-Short Term Bond ETF (ICSH)
Because it is attractive from both a yield/duration risk and a yield/MKT beta risk tradeoff standpoint, I recommend ICSH as a better-yielding substitute for your uninvested brokerage cash. It is a very low-risk bond fund with respect to both interest rate risk and credit risk, and as such is closer to a money market fund than any of the other funds above, while maintaining an attractive yield.
One of the keys to its success is its very low expense ratio: 8 basis points. This gives the fund a consistent advantage relative to more expensive competitors.
Another attractive feature of ICSH is the fact that it is actively managed. An index fund is tied to its underlying index holdings and will tend to buy a representative slice of the index portfolio regardless of credit quality. In fact, the more bonds a corporation issues, the worse its credit, but the larger its weight in the index. An actively managed bond fund has the flexibility to under-weight, or even avoid, weak credits within its universe of issuers. And with an expense ratio of only 8 basis points, investors are not having to pay much for the benefit of active management.
Right now, the 30-day SEC yield on ICSH is .83%. That’s a lot better than .01%. And with risks that are only a hint above those of a money market fund, a very thin expense ratio of only .08%, and the benefits of active management, it is likely to be a very attractive cash alternative for a long time to come.