3 ETFs we use for cash replacement strategies

With the stock market as hot as its been in years, it’s understandable if you’re not rushing to buy right now. But cash is a losing investment more times than not, so what’s an investor to do with new money? Here are three ETFs we use as cash replacement vehicles. This means we’re not holding them for the long-term. But we use them for liquidity needs, or to collect monthly interest while employing a dollar-cost-averaging strategy into our desired investments.

ICSH as a cash replacement

The first ETF we use as a cash replacement vehicle is ICSH, iShares ultra-short-term bond ETF. The ETF is currently paying 2.04% per year or 17 bps per month. ICSH is attractive for its modest yield, high credit holdings, and extremely low-interest-rate sensitivity.

All of these factors combine to make ICSH a very low volatility instrument. For the last 12 months, ICSH has traded in a range of $50.13 – $50.43. In the last 5 years, ICSH has never fallen more than 1% from a high. This makes her an ideal place to store cash that is to be deployed into riskier assets over time. ICSH, with its 2% yield, is also a possible alternative to a traditional savings account. The average interest rate on a savings account is 0.09% (less than 1 bps per month). Puny.

FLOT for hedging real estate

The second ETF we use as a cash replacement vehicle is FLOT, iShares floating rate bond ETF. The ETF is currently paying 2.10% per year or 17.5 bps per month. For the last 12 months, FLOT has traded in a range of $50.63 – $51.03. Over the last 5 years, the largest drop from high to low in FLOT was 1.45%. FLOT is attractive for its yield, credit rating, and the hedge it provides on real estate exposure.

A big risk in real estate investing is rising interest rates. One of the ways to hedge that risk is with short-term, cash-like, securities. Floating rate bonds offer an extra bonus as well. Because yields will adjust higher as interest rates rise, the interest income earned from holding FLOT should increase as well. For example, consider an investor who owns a rental income property. Property owners will often borrow against their equity in one property to fund the purchase of another.

If rates rise, borrowing costs rise. This reduces the borrower’s leverage and makes it harder for the property owner to borrow against existing equity. The simple result of rising interest rates is less leverage and lower profit margins for property owners. So if you’re a real estate investor and are worried about rising interest rates, FLOT is worth a look.

IGSB for income & return

The last ETF we use also comes from iShares, it is their short-term corporate bond ETF, IGSB. This one is riskier than ICSH and FLOT, but would still be considered low risk overall. It holds more than 2,000 short-term investment-grade corporate bonds. But the bonds in IGSB have higher credit risk and interest rate sensitivity compared to ICSH and FLOT.

For that extra risk, the fund offers greater rewards. Currently, IGSB is paying 2.24% per year in interest or 18.66 bps per month. In addition to its interest, IGSB also has some total return potential. As evidenced by its 1-year return of 7% and 3-year return of 3.22%. Which is 300 bps better than ICSH or FLOT over the last year. IGSB has traded in a range of $51.88 – $53.86 over the last 12 months. But from a volatility perspective, the largest decline from a high has been just 2.90% (July 2016-Nov 2018).

What about the risks?

These ETFs are not considered risk free. But in the case of ICSH, it comes pretty close. FLOT’s price might decline if interest rates fall further. Variable-rate bonds held in FLOT become less valuable to the bondholder as interest rates move lower because of the coupon adjusting lower. IGSB is the riskiest of the three ETFs listed. IGSB will be most sensitive to an economic downturn or rising interest rates. However, IGSB is still considered to be a lower risk than longer-dated corporate bonds and certainly lower risk than stocks.

The best template to observe the risks of ETFs like these was in December 2018. That is the only time in the last few years where we saw a major “risk-off” move across bonds, stocks, and real estate. And as you can see in the chart below, these three ETFs held up remarkably well compared to stocks:

SPY, which tracks the S&P 500, fell more than 15% from a September high. For comparison, ICSH fell 0.16%, while IGSB and FLOT each fell 1.32%. So in a risk-off environment, these ETFs can go down. But we still would bet on them holding up far better than stocks. And of course, in a risk-on environment, holding these ETFs will represent a big opportunity cost vs stocks as can be seen over the last few months.

Using these ETFs the right way

We don’t own these ETFs as long-term investments. But they are valuable cash replacement tools in our portfolio. If a client has liquidity needs, we invest in an ETF like ICSH instead of holding straight cash. FLOT can also provide a valuable hedge for anyone with a lot of real estate investment exposure. Another way we use the ETFs is as a bridge to riskier assets. For example, if we have new money that comes in and wants to be 100% invested in stocks, we might use a dollar-cost-averaging strategy.

But instead of dollar-cost-averaging from a cash position, we do it out of ETFs like these. That way the money earns some interest income in the meantime. And in the case of IGSB, we might get some capital appreciation as well. For the ultra-conservative investor, a combination of these ETFs and a few others can provide an effective alternative to a general savings account. Ultimately, these ETFs may not belong in every single portfolio. But they have definite use cases that you should be aware of.

I want to make a quick additional point on the use of ETFs instead of mutual funds. In my opinion, ETFs have a huge advantage as cash replacement vehicles over mutual funds because they can be sold intraday. In a scenario where stocks plummet, money invested in ICSH can easily be sold and reinvested into equity ETFs. The same cannot be said of mutual funds because mutual fund orders execute on the close. And lastly, there are a number of other ETFs that offer similar cash-replacement benefits. Such as NEAR, VGSH, SHY, SHV, BIL, FLRN, SPSB. Do you have any favorite ETFs you use for cash replacement? Tell us in the comments below!