Interest rates are rising, and yet you may not be earning much on your cash. As financial markets finally begin to reflect a recovery from the crisis of 2008-09, the brokerage industry is changing the way they handle customers’ cash, and investors need to pay attention.
Over the past ten years we have become accustomed to earning nothing on our cash. The Federal Reserve kept rates at essentially zero for so long that investors came to expect no return on uninvested funds. It has been a difficult time for savers. Bank CD rates are generally very close to U.S. Treasury rates, and until mid-2016 a 3-month treasury security yielded less than 0.25%. In fact, the Fed dropped rates effectively to zero in December 2008 and finally began to raise them again in December 2015. The 3-month treasury yield has steadily risen along with the Fed Funds rate, from 0.25% in 2016 to over 2% today. By historical standards interest rates are still low, but the increase from zero to 2% is significant for savers and investors of short-term cash.
So why am I still not earning anything on cash?
The short answer is that the brokerage industry is keeping most of the interest earned in sweep accounts for themselves and forcing investors to deliberately invest cash to earn a competitive rate.
Borrowers who compete for funds are compelled by market forces to pay similar rates – otherwise they don’t get the funding they need. So banks selling CDs in the open market have seen rates rise along with treasury yields.
Not all borrowers are forced to compete. Bank deposits and cash balances in brokerage accounts represent something of a captive audience. Years ago, when interest rates were high, and the market was competitive, banks and brokers began offering sweep accounts, where excess cash was automatically swept into an interest-bearing account each night. This arrangement was an important source of profit for banks and brokers as they were able to invest the cash and earn a positive spread, or margin, above what they paid the customer.
When the Fed dropped short-term rates to zero in 2008, the profit margin disappeared from sweep accounts, along with the return to savers and investors.
Fast forward to 2018 and we see that short-term rates have crept back to 2%. At the same time brokers and investment firms have continued to experience competition in other areas of their business; $19.95 was once thought to be an incredible bargain for a brokerage trade. Many brokers now offer trading on an electronic platform with rates below $10, and certain transactions are free. Likewise, the internal management fees or expense ratios for mutual funds and ETFs have been driven downward to the point that Fidelity recently announced some index ETFs with an expense ratio of zero.
In their search for profits, brokerage firms have seized on the sweep accounts as a way for them to make money. Most have transitioned to where excess cash is swept to a bank deposit fund that earns something, but very little. Profits flow back to the brokerage firm because they either own the bank or have some affiliation that returns profit to the brokerage firm. This arrangement has at least one advantage for investors because the bank sweep funds are FDIC insured, but returns are substantially below what we would historically expect from money market funds.
So, what am I supposed to do?
Well the good news is that investors have alternatives. The first strategy is to reduce cash balances where practical. Schwab for example explains that their sweep account is only intended for the minimal cash balances required for near-term transactions. Cash held for a longer period, where the investor wants a return without taking investment risk in stocks or bonds, can be invested in a purchased money market mutual fund. Money invested in these funds is available next-day, rather than same-day in a sweep account.
For Rockbridge clients we are implementing a tighter cash management protocol to reduce balances held in sweep accounts and using money market mutual funds or ultra-short bond funds to generate some return on funds that are not allocated to long-term investment risk.
It is also important to keep this issue in perspective. Our target is to keep cash balances at 1% (now less than 1%), so a $1 million account would have a cash balance of $10,000 or less. If left in the sweep account rather than a fund with 2% returns, the lost income would amount to less than $200 per year.
The terminology and nuances of sweep accounts and purchased money funds can be confusing, so if you have any questions, please give us a call to discuss.