May 15, 2017: Cash: Banking Or Investing?

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Cash: Banking Or Investing?

Many investors are opt to traditional banking for their short term cash. Using a traditional bank not only gives a customer peace of mind as banks are considered to be ultra safe: even in 2008-2009 financial crisis, banks eventually withstood the disaster because of the federal government’s intervention (though some money market funds broke the buck, investors were still able to make their money back). In general, FDIC insurance further covers up to $250,000 to checking, saving, CDs deposits in a bank. Banks also offer much more convenience with their extensive physical branches.

However, online electronic money transfer and ease of investing in index funds or ETFs have provided another way for investors to derive better returns without incurring substantially more risk and sacrificing ease of use. Let’s first take a look at short term bond fund returns vs. CD returns

Short term bond funds vs. CDs

The following chart compares one year returns of investing in VBISX (Vanguard Short-Term Bond Index Inv) or purchasing 1-year CD from 1995 to 2016 (as the fund started in mid 1994). The historical 1-year CD yield is from bankrate.com.

	Compound Annualized	Average Annual
VBISX (%)	3.06%	4.43%
1 Year CD Yield (%)	1.60%	2.60%

Observations

In the past 21 years, there were only three years when the short term bond fund returned less than 1-year CD.
The average bond fund one year return is 1.8% more than the CD. The annual compound average (i.e. assuming reinvesting every year) is 1.4% higher.
There was no losing year for short term bond fund in these 21 years, even in 2008 and 2011, when many ultra short term bond funds lost money (see below).
There were three periods when CD yields rose (meaning interest rate rose): 1996-1998, 1999-2001, 2004-2007. In all of the three periods, the bond fund returned less than CD in the first (1996, 1999) or the second year (2005) but then returned in later years of these periods.

Based on Vanguard, the bond fund’s average effective maturity is 2.9 years, meaning on average, the bonds held in the fund mature in 2.9 years, longer than one year.

The Vanguard index fund has $3,000 minimum and 0.15% expense ratio which is not ideal as a cash substitute. However, its ETF equivalent fund BSV (Vanguard Short-Term Bond ETF) has only 0.06% expense ratio (the expense ratio is lower than many money market funds). If you can trade this commission free such as in TDAmeritrade, Merrill Edge or Vanguard, this fund can be a very good candidate. The following table shows the ETF has a similar or even a slightly better return than VBISX:

BSV vs. VBISX (as of 5/12/2017)

Fund Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR
BSV (Vanguard Short-Term Bond ETF)	1.0%	0.5%	1.3%	1.1%	2.8%
VBISX (Vanguard Short-Term Bond Index Inv)	0.7%	0.4%	1.2%	1.1%	2.8%

Electronic ‘banking’ through investment accounts

Consumers usually have very different views on traditional banking and investing. However, if we look at more closely how one invest in a 1-year CD or in a short term short index ETF or mutual fund, we can see many differences are small enough:

Purchasing and redemption: to purchase a CD, one would go to a bank or visit a bank online and make a purchase. A mature CD would be redeemed automatically and your money is back to your checking or savings account. To purchase a bond fund, one would mostly place a purchase order in his/her online investment account. To redeem, one has to place a sell order.
The main difference here is that to invest in a bond fund, cash has to be first deposited in an investment account. Furthermore, once redeemed, one has to withdraw/transfer money to a bank account.
Many variations on how to transfer money between a bank account and an investment account. Several brokerages also have banking accounts. These include Merrill Edge/Bank of America, Schwab and Fidelity. You can easily transfer between your bank account and investment account. The transfer is usually instant. However, if your bank does not offer an investment account or your investment account is in another brokerage, you probably need to use electronic transfer such as ACH (usually free). ACH can take a one or two days. That’s the inconvenience.
Some brokerage investment accounts provide many banking features such as bill pay, check writing, debit and credit cards. This basically eliminates the need of a banking account. TDAmeritrade’s cash management and Fidelity provide these features. The disadvantage here is that one can mix up a basic ‘banking’ or ‘cash’ account with a general investment account that also invests in some long term holdings or even trading of ETFs, mutual funds or stocks. This sometimes can complicate and confuse investors. To avoid this, you can set up a separate ‘cash’ investment account that’s different from a long term investment account. However, these ‘cash’ investment accounts are still not as feasible as a traditional banking account, which, for example, allows automatic salary deposits.

Discussions

Investing in a short term bond fund can possibly boost your cash returns around 1% or even more in a long term. However, the fluctuation of a bond fund price is certainly the biggest threat to using it as a cash substitute. We want to offer the following rule of thumbs:

If you have some cash that’s not needed for at least a year and would like to purchase a CD with maturity one year or longer, you can consider to purchase a short term bond fund instead of purchasing a CD. At any given year, there is no guarantee that a short term bond fund returns more than a CD, or even doesn’t lose money. However, if your cash can be replenished periodically (such as salary or regular earned income) and you are consistently doing such investment for a long time, it’s most likely you will derive the extra returns. Notice this kind of cash is different from other cash that you can invest in a long term portfolio, i.e. in stocks or longer term bonds.
If you want to invest this kind of cash in a more predictable way, you might consider purchasing individual short term Treasury bills or investment grade bills directly. Remember a CD is really a bank’s way to invest in some short term debts. The return of a CD is after bank’s fees and insurance fees. Purchasing debts directly by yourself removes these fees. In today’s online world, investing directly is no longer a hassle. For example, for ultra safe Treasury bills, notes and bonds, one can use TreasuryDirect.gov. We will have more on this in a separate newsletter.

Again, we want to emphasize that if you estimate that you will invest in a short term bond fund repetitively, it’s very likely that you can gain a better return than a bank CD. However, if your cash is only a one time event, a short term bond fund might not be a good idea. You should consider purchasing a fixed maturity Treasury bill or even a CD. Our observation tells us that many people have just too much cash lying around constantly in a bank account since they are unsure when to need them (but knowing they might need them in some future time).

Market Overview

Markets are behaving like how they have been for the past two years: calm and persistently showing no much fear. For now, as last quarter’s earnings reports are almost over, investors are encouraged with the good year over year earnings growth. Emerging market and international stocks have outperformed US stocks this year. Regardless, U.S. stocks are extremely overvalued and interest rates are still extremely low. Breaking one or the two will surely happen sometime in the future. As we have no predictive power on the near term, we want to emphasize proper risk management and risk allocation. Stay on course.

For more detailed asset trend scores, please refer to 360° Market Overview.

Now that the Trump administration is officially sworn in, the new president is facing the reality to deliver his many promises to make substantial changes. As the nation is posed to invest, the most important factor to watch is how productive the investments will be. Simply put, productive investments will result in better return on investment (ROI), tangibly or intangibly. They should also increase productivity that in turns will improve our standard of living. Capital misallocation can result in a higher growth but might not improve the real standard of living, which is the ultimate goal of economic activities. Whether the new president can truly achieve this goal is still yet to be seen. One thing is certain: we will see more market volatilities.

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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