Image Credit: Christophe Vorlet
By Jason Zweig | Mar. 11, 2016 10:09 am ET
Once upon a time, fund managers kept plenty of cash in reserve in case the stock market tanked. Those days are gone.
When stocks are overpriced, as many analysts believe they are now, your fund manager is just going to keep right on buying them. And when the market drops, your fund manager will have barely any cash with which to scoop up bargains. The job of deciding when to hoard cash and when to invest it is all yours now — much as the shift from pension plans to 401(k)s has made workers, instead of employers, responsible for funding retirement.
Until the late 1990s, fund managers kept much more set aside for a rainy day; between 1986 and 1995, stock funds held an average of 9% in cash. But, as of this Jan. 31, the average U.S. stock fund had only 2.9% of its assets in “liquid assets” (cash and other readily saleable securities), according to the Investment Company Institute, a trade group for the fund industry.
Why have funds been shedding cash? The answer to this seemingly small question reveals bigger truths about how markets are likely to behave in the next downturn. The ascendancy of index funds, those autopilot portfolios that hold all the stocks in a market, has made holding cash into something like a sin. In the next severe decline, only those with cash will be able to buy — but many fund managers won’t be in that group.
For active stock pickers, the math is cruel: All else equal, if stocks rise 20%, then a fund with a tenth of its assets in cash will generate only an 18% gain before expenses. So the more cash stock pickers hold, the likelier they are to underperform in a bull market — and to turn off existing and future investors.
And with the Federal Reserve squashing interest rates toward zero after the financial crisis, cash no longer adds anything to fund returns.
But might this trend have gone too far?
“My preference is always to give my managers room to duck,” says David Snowball, editor of Mutual Fund Observer, a non-profit website that analyzes fund performance. “I would much rather outsource the decision on when to hold or invest cash to someone who is paid to obsess about it on my behalf.”
If you’re going to use any active stock pickers at all, surely you should trust them not only to pick which stocks to buy but also when to buy them — and when to let cash build instead.
A few fund managers still do that, but it isn’t easy to go against the grain.
Consider the Intrepid Endurance Fund, a portfolio of what it says are small, cheap stocks managed by Intrepid Capital Management of Jacksonville Beach, Fla. Fully two-thirds of its $250 million assets are in cash.
“You have to be okay with being called an idiot, potentially for a very long time,” says one of the fund’s managers, Greg Estes. “Most people are just hard-wired to think, when they see the market going up, that there’s no more risk and they should go all-in.”
The fund has outperformed the Russell 2000 index of small stocks by an average of more than 3 percentage points annually over the past decade, but it lagged badly in up years like 2010 and 2013. That, says Mr. Estes, has given investors a “fear of missing out.”
Or take the Pinnacle Value Fund, which also invests in what it says are inexpensive small stocks and has outperformed the Russell 2000 by an average of 0.3 percentage points annually over the past decade. It has only $60 million in assets — of which 44% is cash.
“The fund would probably be a lot bigger if we were fully invested,” says manager John Deysher. “But small stocks have tripled since 2009, and we’re reluctant to chase them just because they’re going up.”
The fund would also probably have performed a lot better if it had been fully invested. With half its assets in cash, Mr. Deysher effectively beat the market with one hand tied behind his back. But he sees almost no “compelling value” left in small stocks and argues that the biggest boost to long-term returns comes from buying “when the market is down 30%, 40%, 50%.”
Some people might feel paying 1.4% in annual expenses to keep half their money in cash is like owning an overpriced money-market fund. But Pinnacle Value’s investors are “comfortable having the portfolio manager, rather than themselves, decide when to buy and sell securities,” says Mr. Deysher. “It takes that burden off their shoulders and puts it on mine.”
Managers like Mr. Estes and Mr. Deysher have become rarer than white rhinos. In 2009, 4.1% U.S. stock funds had at least a quarter of their assets in cash, according to Morningstar; today, only 1.6% do.
At the end of 2007, shortly before the onset of the financial crisis, U.S. stock funds had a total of $176.8 billion in cash, according to the Investment Company Institute. Today they have $164.4 billion. Yet the S&P 500 has since risen in price by more than more than 35%, and U.S. stocks trade at roughly a 15% higher multiple of their profits now than they did then.
If the market crashes again — as it will someday, just as surely as the sun sets in the west — investors will suddenly realize how vital it is to protect yourself with plenty of cash. No one else is going to do it for you.
Source: The Wall Street Journal