What it means
Every fund needs some cash. Investors can sell their fund units on any business day, and the manager must pay them without being forced to sell investments at a bad moment.
Cash also gives the manager room to buy bargains when prices fall. Beyond that practical need, managers sometimes raise cash deliberately because they are cautious about the market.
A fund with a high cash level is saying that it sees few attractive buys, or that it expects prices to fall. A fund with a very low cash level is almost fully invested and is relying on rising markets.
The cash level has a cost. Cash earns a low return compared with shares over long periods, so holding a lot of it drags down performance when markets rise, an effect known as cash drag.
On the other hand, in a falling market, cash cushions the loss and gives the manager money to buy at lower prices. Market commentators use the average cash level of all funds as a contrarian indicator.
When funds hold unusually large amounts of cash, there is a great deal of money waiting to be invested, which some read as a sign that the market could rise once confidence returns. When cash is unusually low, there are few buyers left to push prices higher, which some read as a warning.
These readings should be used carefully. The cash level of one fund tells you about its manager, but it does not predict the market, and the figure also moves for reasons such as large inflows or redemptions.
It is best treated as one input among many, not a trading signal on its own. The type of fund also changes how the figure should be read.
Money market funds are almost entirely cash by design, while balanced funds may hold a moderate amount as part of a deliberate mix, and index funds usually hold very little. Comparing a fund's cash level with its own history and with similar funds is more informative than comparing it with the whole market.
In practice
Real-world examples.
Example
A fund manager who believes shares have become expensive lets her cash level rise from 4% to 12% over a year. When prices later fall sharply, she uses the cash to buy companies she has long wanted at lower prices. She records her reasoning in the fund's quarterly report so that investors understand the choice.
Example
A pension adviser compares two share funds with similar holdings but cash levels of 2% and 9%. He explains to his client that the second fund will probably lag in a strong market but hold up better in a weak one. He suggests the client hold both funds in different proportions to balance the two styles.
Example
A market strategist reports that average cash levels across a large group of funds have reached an unusually high point. She tells clients this suggests a lot of money is waiting on the sidelines, though she cautions that it is not a guarantee of a rally. She also checks whether inflows into funds are unusually large, which can inflate the cash figure.
Formula
Calculation
Cash level = Cash and equivalents / Total net assets x 100
Cash drag = Cash level x (Return on investments - Return on cash)
Suppose a fund has net assets of $60,000,000, of which $3,000,000 is held in cash. Cash level = 3,000,000 / 60,000,000 x 100 = 5%. If the rest of the portfolio earns 8% and cash earns 2%, the cash drag = 5% x (8% - 2%) = 5% x 6% = 0.30%. On $60,000,000, the drag costs 60,000,000 x 0.0030 = $180,000 a year in returns.Case study
Seen in the real world.
Blue Harbour Growth Fund is an illustrative, fictional fund with $200,000,000 in assets and a stated policy of holding no more than 10% in cash. Early in the year, its manager holds 3% in cash because he sees plenty of attractive shares.
Later, markets look overheated, and he sells some holdings until cash reaches $24,000,000, or 24,000,000 / 200,000,000 = 12%, slightly above the usual limit. The board accepts this temporarily because the manager explains the reasons in writing.
When the market falls 15% a few months later, the fund falls only about 11% because of its cash, and the manager reinvests at lower prices. The illustrative lesson is that a higher cash level costs returns in good times but can protect and create opportunity in bad times.
Watch out
Common mistakes.
- Treating a high cash level as proof that the manager knows a crash is coming.
- Ignoring the cost of holding cash in a rising market.
- Comparing cash levels between funds with very different purposes, such as a money market fund and a growth fund.
Questions
People also ask.
Why do funds hold cash?
They need it to pay investors who sell units, to cover costs and to buy new investments when opportunities appear.
Is a low cash level bad?
Not necessarily, because it may only mean the manager is fully invested, but it leaves less room to meet withdrawals or to buy during a fall.
Where can I find a fund's cash level?
It is shown in the fund's regular reports and fact sheets as part of the asset breakdown.
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