The Investment Company Institute, the trade association for mutual fund management companies, just issued a periodic report on mutual fund inflow and outflows. Among other things, it shows that the percentage of cash held by equity fund managers–with both international and US-only mandates–dropped over the past year from 5.7% to 3.6%. This is a shrinkage in dollar terms from $210 billion to $173 billion, despite a rise in overall assets during the twelve months.
Bloomberg, citing Wall Street strategists, says this is a bad thing. Why? In their view, it’s because a low cash percentage signals an impending market decline. Noting this, investors stop aggressively buying stocks. Huh?
I don’t think this is right, for several reasons.
1. Most mutual fund managers also manage money for institutional investors. Institutions demand that their managers keep little or no cash. A full explanation is complicated, but basically they don’t want the managers they hire to do market timing.
Can a manager have a different policy for mutual fund customers? Probably not. If nothing else, two different policies means the possibility of two different investment results. This, in turn, means the potential for at least one unhappy customer–the one who got the lower returns.
So the institutional “style” determines the low-cash policy of mutual funds.
2. Managers don’t want to hold cash, because cash is potentially such a drag on performance. For an equity manager, having a lot of cash is akin to a baseball player leaving the weighted donut on his bat when he finishes warming up and strides to the plate. A simple example:
Let’s assume cash generates a zero return. If the S&P rises 20% in a given year and a manager matches the market with his stocks and holds no cash, his return is 20%. Maybe that won’t get him a big bonus, but at least he lives to fight another day.
If the same manager holds 10% cash, his return is .9×20 + .1×0 = 18%. He’s two hundred basis points below the market. A couple of years like this and he’s thinking of new career options.
3. You need some cash, though. The timing of buys and sells may not always match precisely, so a manager has to have a little cash to deal with this friction. Also, in the mutual fund world, a manager has to have enough cash to satisfy possible daily redemptions. Management companies all have something akin to overdraft lines to cover large unanticipated withdrawals, but a manager takes his life in his hands if he does something to trigger their use.
A load fund manager probably needs 1% cash to meet these needs, a no-load fund manager is probably under most circumstances with twice that. But there’s no real reason–other than that you have a strong conviction that the market is going to (continue to) go down–to hold any more.
Conventional wisdom says cash remains pretty constant
When I had been in the stock market for a couple of years, and was very interested in technical analysis, I was speaking one day with a statistician friend about just this topic–the percentage of cash held by mutual funds as a predictor of future stock market performance. He pointed out that if you charted the cash percentages and then flipped the chart over, you got a chart of the S&P 500. In other words, the variation in percentage was not due to portfolio managers fine-tuning their cash holdings, but to changes in the value of the stocks in the portfolio, which made a constant amount of cash into a differing percentage of assets.
He was right.
In the case we’re talking about, from December 2008 to January 2010, stock mutual fund assets rose from $3.7 trillion to $4.8 trillion. If cash had remained constant, its percentage of assets would have dropped from 5.7% to 4.0%. That’s virtually all the difference in the actual cash percentages.
The remainder? Remember back to January of last year. It was one of the scariest times I can remember as an investor. Certainly no one was rushing to invest new money. Instead, managers were likely raising cash in anticipation of possible redemptions. All that changed in March, when world markets began giving the same valuation signals they were at the bottom in 2003. If that weren’t enough, the market action itself began to signal the all-clear.
I attribute the remainder of the difference to the switch, both by managers and their investors, from despair to a better frame of mind.
Managers do know one reliable bearish signal…
It’s when they start to get lots of new money into their funds, and the phone begins ringing for newspaper and television interviews. Most individuals don’t have a systematic approach to investing, in my opinion. They are rarely interested in out-of-favor asset classes, industry groups… Instead, they like what has been going up for a while–sometimes even for several years. And they start to buy much closer to the top than they care to admit.
Recently, I’ve been hearing on the radio advertisements for gold investments. I presume they’re successful in attracting business to the advertisers, because the keep on running. Their main point: gold has quadrupled in price over the last ten years, while stocks have stagnated or gone down. Therefore, buy gold, not stocks.
These advertisements should scare the wits out of any holder of gold who believes in “Buy low; sell high.” In one or two sentences, they make the positive case for stocks. But their actual effect is the opposite.
When an equity manager has had, say, two years of 30%+ returns, his management company decides a sales campaign may gather assets, and lots of money flows in, he knows his period of outperformance is close to over and he should become more defensive. This is just human nature speaking to him.
…which is far from flashing today
After massive outflows from equity funds in 2008, there were virtually no net inflows for 2009, despite the sharp gains for the S&P last year. Instead, individuals pumped huge amounts of money into bond funds.
Yes, a bear market in stocks may be just around the corner. Personally, I don’t think so–but you never know. History, however, and the portfolio inflow indicator say one in bonds is much more likely.
More on the ICI numbers tomorrow.