What to Think About if There’s a Big Cash Stash

Check under the hood of a fund these days and you could discover that your money manager is a quart low on investments.

With the stock market at record highs, a lot of managers--notably bargain-hunting value investors--are having a hard time finding stocks they consider worth buying. The result is increased cash holdings that, in turn, are holding down returns.

Worse yet, a dipstick measure showing big cash holdings makes it look as if a manager is trying to time the stock market. As former Fidelity Magellan manager Jeff Vinik proved a while back when he gave his stock fund a huge position in bonds, investors get nervous when they see a money manager doing something unexpected.

The growing cash stash among popular funds may cause some investors to revisit a philosophical decision: namely, whether to pick funds that are fully invested or to leave allocation decisions to a pro.

“Any mutual fund manager who holds onto cash waiting for a better opportunity is to some extent a market-timer,” says Steve Shellans, editor of the MoniResearch Newsletter. “But there is a fine line between someone with a disciplined investment approach who can’t find value and someone who says this is time to be out of the market. You should know the difference before assuming a manager is doing something wrong.”

According to the Investment Company Institute, the average cash reserve among domestic stock funds is below 5%. Yet there are plenty of funds with percentages that are far greater.

Consider, for example, that Oppenheimer Growth Fund in its most recent report said 42% of its assets were in cash, according to CDA Wiesenberger, a Rockville, Md., industry research firm.

Crabbe-Huson Special, Third Avenue Value, Heartland Value, Janus Olympus, Clipper, Merrill Lynch Growth, FPA Capital, Yacktman and the Franklin Mutual Series funds are among other popular funds with cash reserves near or even well above 20%.

To the managers of these value-oriented funds, suggesting that their actions are market-timing would be fighting words.

“The difference,” says Michael Stolper of the Mutual Fund Monthly newsletter, “is that these guys would buy stocks if they could find anything worth buying. A market-timer believes the whole market is overvalued and won’t buy anything.”

Indeed, value managers operate on a bottom-up basis, looking first for companies that should prosper without regard to broader economic conditions. Many growth-stock investors also function this way, although their ability to find suitable investments is less affected by the market’s big run-up.

Market-timers, by comparison, invest from the top down, first deciding if economic conditions allow for persistent gains.

The problem is that an investor can wind up a loser following either system by holding too much cash during a bull market.

“Investors aren’t unhappy when a manager goes to cash or Treasury bonds; they become unhappy when the fund starts to underperform and the decision looks wrong,” says Paul Merriman of the Merriman Funds, where most offerings are managed by market-timing. “If you don’t understand how a manager runs your fund, you won’t stick around for an explanation when things go bad.”

Most of the value managers with mounting reserves have, as Stolper notes, “wrinkles around their eyes.” This is not the first time they have had trouble finding bargains.

But unlike the way it was in those previous occasions, investors now are much more aware of what it means to be “fully invested,” thanks to the outstanding performance of index funds, in which all but a tiny fraction of assets are in the market.

Just three of the best-performing 30 value funds this year have more than 10% of their assets in cash, according to CDA Wiesenberger. Fully invested funds populate the rest of the chart.

Many investors want to make their own asset-allocation decisions, divvying up money among stocks, bonds and cash. When a stock fund holds excessive cash, it can distort that process.

Many value managers admit hearing from shareholders telling them to play the game rather than ride the bench. But the managers resist, knowing that breaking their discipline and investing too aggressively invites failure. Moreover, today’s cash-rich funds may be fully invested again after the next big downturn.

With that in mind, experts suggest focusing on a manager’s system and not on the cash reserve. After all, you are paying for the manager’s judgment, even if that judgment is that there is nothing worth buying now.

“There are periods of time in this business when you look dumber than you really are,” laments Donald Yacktman, whose Yacktman Fund is 22% in cash and is lagging the average growth fund after three years in the top 20% of its peers. “I’m frustrated too, but I have to be true to the way I invest. The one thing I would enjoy less than underperformance near the top of the market is the free fall that comes with going over the top. Investors who don’t want that discipline probably belong in a different kind of fund.”

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Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at [email protected] or at the Boston Globe, Box 2378, Boston, MA 02107-2378.