Five Years Later: Fund Managers and Cash Stakes

Gregg Wolper

In a Fund Spy column published five years ago, I asked readers if fund managers should have the flexibility to raise meaningful cash stakes if they were having trouble finding stocks they wanted to own at their current prices or if they felt uncomfortable with overall market levels or economic conditions.

That column appeared in response to the climate at that time. Stock markets around the world had been plummeting more or less steadily for almost a year and a half, and gloom was widespread. It was early February 2009, just five weeks before the lowest point of the brutal bear market caused by the global financial meltdown, and frustrated investors were voicing their dismay about fund managers who had remained fully invested, riding the decline all the way down, rather than protecting them by raising cash.

That had not been a common refrain during the lengthy stock-market rally that had preceded the crash. When most of the world's market were rising steadily, advisors and individuals alike expected managers to stay fully invested and to stick to their assigned mandates. Cash stakes of any significant size held down fund returns and complicated investors' asset-allocation targets. (Note: We're talking mainly about stock funds here, not allocation funds or tactical vehicles that by definition are expected to shift money around to different asset classes.)

Even though pro-cash sentiments previously had been rare, it made sense that the overwhelming amount of respondents to my February 2009 query said they wanted their managers to have the flexibility to raise cash and to do so when markets turned rough. After all, watching your portfolio deteriorate month after month in a punishing market crash, paying advisory fees all the while, can wear away long-held convictions.

Time to Check In Again?
It was tempting to simply ask the same question again at this point. And opinions on the issue are certainly welcome from those who care to share them in the comment box below or elsewhere. But upon reflection, it did not seem appropriate to simply redo this exercise. For one thing, it wasn't a scientific poll last time and wouldn't be this time, either. Asking again also might seem flippant, as if the purpose were simply to catch people reversing their opinions in response to a rally.

In addition, the timing became complicated. Asking the question at the end of 2013, after a second straight year of powerful stock-market gains, would have provided a clearly contrasting environment to February 2009. But January's sharp market decline has muddied the waters. Thus, it wouldn't be clear if investors who maintained that they wanted their managers to have the flexibility to raise cash were admirably sticking with their conviction even after a long rally, or were simply reacting to the downturn of the past few weeks.

Not a Simple Matter
Looking at the responses from February 2009, it is striking how enthusiastically people sided with flexibility at that time. It should be noted that the responses were thoughtful and nuanced; readers weren't simply demanding that all of their managers jump into cash whenever the stock market slid. But the majority did expect at least some of their fund managers to provide protection when markets fall by trimming their exposure to stocks and raising some cash.

That's not necessarily an unreasonable view. But readers who share that opinion today should bear in mind that their managers are unlikely to get the timing precisely right. In fact, most stock-fund managers that do have the flexibility to carry substantial cash stakes aren't trying to time the markets at all; they're just reacting to what they consider the excessive prices of the individual stocks they'd like to buy. Whatever their motivation for holding cash, though, their funds' returns will likely come up short if markets keep rising while a significant portion of their portfolio is sitting on the sideline.

There were plenty of examples in 2013. Invesco International Growth (AIIEX) is one. It had an attractive long-term record heading into the rally of 2012-13, but it lagged in 2012 and had a mediocre 2013. While there were several reasons why the fund didn't shine the past two years, unusually high cash stakes played a significant role. Historically, this fund was almost fully invested, but in 2013 its cash level stood at around 10% of assets until late in the year.

A similar situation arose at FMI Large Cap (FMIHX) and FMI Common Stock (FMIMX). (The latter's cash stake peaked at 22% of assets in 2013). They didn't lag their category averages by large amounts last year, but their so-so returns were significantly lower than they would have been had that money been invested--assuming, of course, that the managers didn't choose to invest that money in the relatively few stocks that declined.

Longleaf Partners Small-Cap (LLSCX) went even more heavily into cash. The managers of that fund, the same duo that runs flagship Longleaf Partners (LLPFX), have never worried about holding outsized cash levels in either fund if they couldn't find enough stocks that meet their strict standards. Even for them, though, holding more than 40% of assets in cash, as Longleaf Small Cap did for most of 2013, was quite unusual. The fund has one of the best long-term records in its group, but with such a hefty cash pile it's no surprise that it lagged roughly three fourths of its rivals in the mid-blend category last year.

Weitz Value (WVALX) didn't go quite that far, but its cash stake of more than 25% of assets was one of the largest in the large-blend category in 2013. As a result, it landed only in the middle of that group in 2013, even though its top holding, Valeant Pharmaceuticals (VRX), which took up 5.6% of assets entering 2013, soared 110% for the year.

Of course, cash stakes didn't automatically relegate a fund to mediocrity in 2013. Fairholme Fund (FAIRX) landed in the top quartile of the large-value category and beat the S&P 500 Index by 3 percentage points, even with a cash stake that ranged from the high single digits to the low teens. And FPA Crescent's (FPACX) cash stake of more than 30%, a steep figure even in its moderate-allocation category, didn't prevent it from outperforming peers with much higher equity allocations and winning its managers the nod as Allocation Fund Manager of the Year.

The Saving Grace
Even for funds that did underperform owing partly to large cash holdings, it's important to note their absolute returns along with their unimpressive rankings. It's one thing for a fund to lag when suffering a huge loss, but far less damaging if it still gains around 30% for the year, as Weitz Value, Longleaf Small Cap, and FMI Large Cap all did in 2013. Their respective category averages were in the 30% to 35% range, so shareholders didn't give up too much for the "insurance" provided by their managers' caution.

Of course, that result is not guaranteed. A fund sitting on a comfy pile of cash during a strong rally could trail its peers and benchmark by much wider margins. But in many cases they will outperform during declines, and that performance pattern can add up nicely over time.

All in all, there need not be a definitive answer on whether funds should have the flexibility to raise cash stakes. As a few respondents noted in 2009, some investors prefer that some of their funds remain fully invested at all times while allowing others more leeway. Moreover, some funds could have flexibility, but only to raise cash to a maximum of 10% or 20% of assets, say, while others could be allowed nearly unlimited freedom.

What's most important is that investors understand their own preferences and have a firm grasp on their funds' strategies, including their approach to this issue. Then, there will be less chance of disappointment or surprise, and a reduced likelihood of selling at the wrong time. In short, there's room for many different methods; the key is to know them and use them prudently.