Investment Ideas


Cash Equitisation

Managing excess reserves or periodic cash flows efficiently is an essential element of high quality institutional portfolio management. When an investor has a large temporary cash position, the respective portfolio is likely to be tilted away from its target allocation to equities or fixed income. In a rising market, this could result in a cash drag and hence performance shortfalls relative to the benchmark. To overcome this drag on performance, investors can employ a cash equitisation strategy. The aim of this strategy is to remain fully invested while maintaining liquidity.

 


Assets

$678B

Global ETF assets under management 1


Experience

1993

Launched the first US-listed ETF


Offering

252

Global number of ETF offerings 2


Uses of ETFs: Cash Equitisation


Exchange traded funds (ETFs) were initially created to provide institutional investors with a means to equitise these cash positions using a fund structure backed by physical securities (as opposed to using derivatives). Instead of having a significant cash position, investors can select an ETF that closely approximates their target market and risk exposure. This enables the investor to remain fully invested and minimise the risk of performance shortfalls in rising markets.

A cash equitisation strategy through ETFs is useful for institutional investors who are transitioning assets between managers. It remains a common rationale for ETF use, and is arguably more important than ever when yields on cash assets are close to zero.


A Complement to Futures


While the use of ETFs for cash equitisation may be popular with overseas asset managers, Australian investors generally prefer using futures as a cash equitisation tool. Futures may offer a liquidity advantage, but using ETFs for all or part of a cash equitisation program is likely to enhance returns and provide better after-tax outcomes for investors.

Compared to futures, ETFs:

  • Are more tax effective due to their accounting treatment and the earning of franking credits. Most Australian-domiciled Managed Investment Schemes investing in growth assets operate on a ‘capital account’ basis, with capital gains treated as such, allowing unitholders to benefit from the 50% capital gains tax discount for securities held longer than twelve months. Any income received by the fund is also treated as such, with net income together with realised capital gains paid to unitholders in the form of a distribution at the end of each year. This creates problems for funds using futures. Returns on a futures contract are generally treated as income, operating on a ‘revenue account’ basis. As a result, instead of receiving a capital-style return, investors receive a non-discountable income return; all gains are typically realised every three months at the contract roll, bringing forward the tax event; and gains and losses on the futures contract affect the income distributed to investors. 
  • Preserve distributable income and the value of associated franking credits in bear markets. While ETFs can earn and distribute franking credits, no franking credits are earned through holding futures contracts. As a result, ETFs can provide a valuable source of additional income for investors, while enhancing a fund manager’s after-tax performance.
  • Present challenges for short term funding needs. Futures have a clear liquidity benefit compared to ETFs. The concern is not the liquidity of the ETF itself. Instead, the point of interest for institutional asset managers is the timing of settlements. Some institutions settle redemptions to unitholders on a shorter timeframe than the settlement period for both ETFs and the underlying assets of a typical equities fund. In this case, the redemption will need to be paid before the manager can exit the ETF position, which may result in an overdraft with its associated costs. Futures avoid this problem, since they are only partly funded and settle on a tighter timeframe. Investors may consider using a combination of ETFs and futures, in order to balance income benefits against liquidity.

Cash Equitisation With SPDR ETFs


We launched the first US-listed ETF in 1993 as a cash equitisation vehicle for institutional investors. Since then, institutions remain some of the largest investors in ETFs, with usage continuing to expand across a wider range of investors and investment strategies.ETFs offer investors further benefits –they are low cost, simple, tax efficient and easy-to-access investments.


Insights


SPDR Bond Compass - Quarterly Report

Understanding ETF Liquidity

One of the main advantages of ETFs is that they offer liquidity from two sources. From the surface, it may be obvious that there is liquidity as defined by the trading volume and bid/ask spread in the secondary market. Beneath this is another source of liquidity in the primary market that may often be missed. 

Related Insights


More information

1 Source: Morningstar, as of March 31, 2019.
2 Source: Morningstar, as of March 31, 2019.



Important Information

Derivative investments may involve risks such as potential illiquidity of the markets and additional risk of loss of principal.