Toronto – Mutual fund investors should be cautious about funds holding low amounts of cash, says a researcher from the University of Toronto's Rotman School of Management.
That's because funds with high amounts of cash actually outperform those whose managers keep cash reserves low, by nearly 3 per cent annually, shows the study by Mikhail Simutin, an assistant professor of finance at the Rotman School.
"I was surprised when I found that positive relationship," says Prof. Simutin. "It went against my original intuition."
Keeping high amounts of cash can act as a drag on fund performance because it means investors' money is not actively engaged in equity markets and benefiting from those markets when times are good.
But Prof. Simutin's study found that fund managers who kept unusually high amounts of cash made up for that drag by making smarter stock picks when good opportunities arose. They also avoided "fire sales" of equities to cover costs when large numbers of investors cashed out of the fund. That added up to superior performance compared to funds with low cash assets.
"Low cash funds suffer especially badly when market-wide liquidity is low, such as, for example, what we saw in 2008," says Prof. Simutin. "If you see a fund that routinely holds very little cash, you have to ask if there's a good reason why," he says. "Is this manager going to be prepared if bad times hit?"
This is one of the few studies that have explored the effect of cash holdings on mutual fund performance, something Prof. Simutin finds puzzling, given that cash is an important component in most funds. Some $5.7 trillion was invested in actively-managed U.S. equity funds at the end of 2010, with $170 billion of that, or 3 per cent, held in cash. But there can be dramatic differences between individual funds' cash positions. The bottom 10% of the funds holds less than 0.18% in cash and while the top 10% holds 9% of assets or more in cash.
The paper was published in the July 2014 issue of the Review of Finance.
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