Mutual Funds: Cash Levels and Active Management

by: Kevin S. Price

In yesterday's reading list, we mentioned a Jonathan Burton story on varying levels of cash in mutual funds. Burton mentions a few funds that have maintained relatively high levels of cash in recent weeks, noting that some of these funds have performed well even as the equity markets have rebounded off their January and March lows.

Here are a couple relevant excerpts:

The volatile stock market and the weak economy have derailed many mutual-fund managers, but without the ability to bet against stocks, some are playing defense the only way they can -- by holding more cash.

In recent months that's been a smart move. Cash is king when stocks head south. A sizeable allotment to short-term Treasury bills and other cash-equivalent vehicles can dodge the worst blows of a down market and absorb its unpredictable shocks. Moreover, money on the sidelines lets a cost-conscious manager scoop up bargains as they appear...

Yet this seemingly safe route is not without its own risk. Cash is trash when stocks rebound. Clinging to cash at those times creates a drag that can transform a leading fund into a laggard. Since no one knows when markets will turn, and given the constant pressure -- from both their shareholders and their bosses -- to outdo a benchmark index, most fund managers stay as close to fully invested as possible; the average diversified U.S. stock fund keeps only about 4% of its assets in cash, according to Morningstar.

Financial advisers in particular look askance at funds with outsized cash positions. Advisers set and adjust portfolio allocations between stocks, bonds, cash and other investments based on a client's risk profile. A cash-rich fund can upset those plans, says Dan Moisand, an investment manager at Spraker Fitzgerald Tamayo & Moisand LLC in Melbourne, Fla.

"If you're hiring managers to buy and sell stocks, that's what they should be doing," he says. "We should be making the cash decisions, because we're closer to the client."

Now, this leads to an interesting and important discussion.

In one sense, Dan Moisand is entirely right: Advisors are closer to their clients, and they should make the big asset allocation decisions. But there's another sense in which we think Moisand is on the wrong track.

When clients want active management (i.e., the explicit pursuit of alpha through some combination of outperformance in strong markets and capital preservation in weak ones), we think they should get it in a framework that's meaningfully different from the typical mash-up of active and passive exposure delivered by conventional long-only funds.

One of the key differences between tracking-error minimizers and true active managers is that the latter are less constrained than the former, in particular in the sense that their investment mandates do not require them to be (more or less) fully invested in all market conditions. After all, money management is risk management, and managing risk can be done in one of two ways: (1) strategic asset allocation and radical diversification or (2) active hedging of one sort or another (using options, short positions, cash levels, &c.). Both methods are perfectly legitimate. But they're different! And they need to be understood, pursued, and sold differently.

Burton's certainly right that large cash positions can weigh on performance during strong market episodes. But the essence of successful money management is in delivering market-beating returns for the same level of risk or market-like returns for a lower level of risk.

If advisors are frustrated with fund managers who maintain high cash levels (or whose cash levels vary somewhat unpredictably), they should look elsewhere for pure asset-class exposure, in particular to the inexpensive ETFs and index funds designed to provide exactly that.

If they want active managers, and are willing pay for same, they should know that varying levels of exposure to risky assets is part of what any self- and investor-respecting money manager should deliver.


Jonathan Burton, "Kings of Cash," MarketWatch, May 11, 2008