Exchange-traded funds (ETFs) are popular for lots of reasons. One of many is the ability to "equitize" cash and minimize "cash drag."
For most asset managers and individual investors, there are several reasons they typically underperform benchmarks. The behavioral tendency to chase performance (buying something after it has risen substantially or selling something after it has gone down) is arguably the biggest reason. Costs, both transaction costs and the cost of simply owning an investment, are another major factor.
Another big reason, and one that is often underappreciated, is many investors typically hold cash - even if they consider their portfolios "fully invested." Cash might be held for a variety of reasons. The list can include the anticipation of redemptions or the lack of specific investment ideas. It might even just be there for comfort. (Some managers, however, do like holding cash to take advantage of fresh opportunities that might suddenly appear).
And holding cash can matter. If a portfolio holds 10 percent in cash, for instance, and the stock market outperforms cash by 10 percent, this will cost 1 percent in performance. Depending on market conditions and the expense ratio of the portfolio in question, holding cash might be the biggest detriment to performance. (Holding cash is a big reason, of course, that many investment portfolios have a better chance of outperforming benchmarks in down markets, but since the markets are usually up most of the time, holding cash usually works out to be a drag.)
To fix this cash drag, an investor could simply invest in an ETF. And, when the investor eventually has the need or an idea how to put the money to work, she or he could easily sell the position. For example, if the mandate for a manager is domestic large-cap equities, cash could be equitized by using the SPDR's S&P 500 (SPY), IShares Core S&P 500 (IVV) or Vanguard's S&P 500 (VOO). If the mandate is inflation-protected bonds, cash could be equitized by using either iShares TIPS Bond (TIP) or PIMCO's 1-5 Year US TIPS Index (STPZ).
The beauty of using ETFs to minimize cash is its two key attributes: style purity and liquidity. An ETF provides a dependable market exposure. There is no "style drift" (i.e. an unexpected change in a fund's attributes). And it can easily be sold.
For some institutional managers, it's easier to manage cash and liquidity using ETFs instead of managing continuous inflows and outflows from multiple managers. For many of these same managers, who get measured and managed on a metric called "tracking error" (i.e. the return difference between a portfolio's return and its benchmark return), equitizing cash also minimizes this key risk. Lastly, using ETFs may even be cheaper than buying individual securities, which may have higher transaction costs.
There are costs to be considered though. First, there are transaction costs to trading ETFs. There might be a small commission and, of course, there is a bid-ask spread to be considered. To minimize these costs, using the most liquid ETFs in the desired market space makes the most sense. Another cost, at least for taxable investors, is the tax incurred when realizing short-term gains. In this scenario, the potential tax costs need to be compared to the potential cash drag. This should be carefully considered. Sometimes it will make sense to equitize the cash, and sometimes it may not.
In the end, ETFs are an excellent tool to help investors close the gap between portfolio returns and market returns by helping to minimize cash drag.
Disclosure: The author is long SPY, IVV, VOO, STPZ, TIP.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.