Extra mutual fund cash is a good sign for investors
Saving for a rainy day
Mutual fund investors should be cautious about funds holding low amounts of cash. Funds with high amounts of cash actually outperform those whose managers keep cash reserves low.
It’s an established truth of investing that keeping high amounts of cash can act as a drag on fund performance. Why? Because it means investors' money is not actively engaged in equity markets and benefiting from those markets when times are good.
However, funds with high amounts of cash actually outperform those with low cash reserves by nearly three per cent annually, shows the study by Mikhail Simutin, an assistant professor of finance at the Rotman School. "I was surprised when I found that positive relationship," says Prof. Simutin. "It went against my original intuition."
"If you see a fund that routinely holds very little cash, you have to ask if there's a good reason why."
- Mikhail Simutin, assistant professor of finance
The study found that fund managers who kept unusually high amounts of cash made up for that drag by making smarter stock picks when good opportunities arose. They also avoided fire sales of equities to cover costs when large numbers of investors cashed out of the fund. That added up to superior performance compared to funds with low cash assets.
"Low cash funds suffer especially badly when market-wide liquidity is low, such as, for example, what we saw in 2008," says Prof. Simutin. "If you see a fund that routinely holds very little cash, you have to ask if there's a good reason why," he says. "Is this manager going to be prepared if bad times hit?"
This is one of the few studies that have explored the effect of cash holdings on mutual fund performance, something Prof. Simutin finds puzzling, given that cash is an important component in most funds. Some $5.7 trillion was invested in actively-managed U.S. equity funds at the end of 2010, with $170 billion of that, or 3 per cent, held in cash. But there can be dramatic differences between individual funds' cash positions. The bottom 10 per cent of the funds holds less than 0.18 per cent in cash and while the top 10 per cent holds 9 per cent of assets or more in cash.
Read the full news release.
The Major in Funds Management