When you invest in a mutual fund, you are trusting a fund manager to pick securities on your behalf. Many investors make this decision because they feel the manager can do a better job than they would do on their own. For others, it's simply more convenient to have someone else responsible for researching and selecting investments.
The common denominator, though, is that investors typically expect that their money will be put to work. So what happens when your fund doesn't seem to be doing much investing at all? Put another way, should you be concerned if your fund is sitting on a pile of uninvested cash?
While there is no hard-and-fast rule, if you are invested in a fund that has more than 10 percent of its portfolio tucked away in cash, you should start looking for an explanation. Funds can hold cash for a number of reasons. Here are three of the most common ones:
Opportunistic buying. Some managers like to have cash on hand to snatch up securities at attractive prices. When a fund is fully invested, management has to sell existing holdings in order to have enough money to buy new ones. Unwinding positions, however, can take time. The process can also result in management selling holdings at the wrong time. With a cash reserve, though, management can pounce on opportunities as soon as they arise.
Sometimes, a fund's tendency to invest in this manner will be obvious from its name. Take, for instance, Alpha Opportunistic Growth. As of the end of the second quarter, cash accounted for more than a fifth of the fund's portfolio. As the fund's name suggests, management likes to remain nimble. Investors who are considering owning a fund which, like this one, holds cash opportunistically need to ask themselves how much they trust the fund's management to identify and seize on good deals.
Defensive investing. During tough times, fund managers will often increase their exposure to cash. To be sure, this limits losses. After all, during a downturn, money that is functionally tucked away under the mattress isn't going to disappear in the same way that money invested in the stock market would.
Investors surely appreciate successful efforts to limit losses. But the problem with this form of defensive investing is that it is a type of market timing. Funds that are fully invested will get hit hard during downturns, but they will also benefit more fully from recoveries.
It is possible to have the best of both worlds. For instance, sitting on the sidelines in 2008 and getting back into the market in March 2009 would have yielded spectacular results. But managers who can consistently make such calls with any degree of consistency are few and far between.
Recent inflows. Popular funds will often get large inflows. As a fund gets larger, it can take time for management to put all of the money to work. This is natural and is usually no cause for concern. However, if your fund's assets under management grow very rapidly, there is a chance that the fund is getting too big for its own good.
In general, the larger the fund, the less nimble it is. That means that management often won't be able to seize on opportunities as they arise. In those cases, funds are considered overly "bloated." Unfortunately, though, there's no precise rule of thumb for when a fund becomes too big. Indeed, many managers are able to handle large asset pools with tremendous success. A prime example is PIMCO's Bill Gross, who manages the company's Total Return fund. Even with $270 billion under management, the fund is still one of the most successful offerings available.
Ultimately, sitting on cash is neither inherently good nor inherently bad. But it goes without saying that cash is not going to earn much in the way of returns. By staying out of the market, your fund may be losing out on opportunities to effectively put your investments to work. Because of that possibility, if you are invested in a fund that has a large cash stake, it's worth understanding why management is on the sidelines. Getting that answer can help you pick the optimal mutual fund lineup.