As investors buy, managers sock away cash

'Markets turn very unexpectedly,' warns ICMCX' Estes

Nov 27, 2013 @ 9:45 am

By Jeff Benjamin

As retail investors continue to jump on the stock market bandwagon to join the strongest rally since 2009, a growing list of professional portfolio managers are heading in the opposite direction by unabashedly seeking shelter in large piles of cash.

“We're value managers with a bottom-up process, and when we can't find anything to own, our default position is to go to cash,” said Greg Estes, vice president and portfolio manager at Intrepid Capital Funds. That point is made crystal clear by the whopping 62% cash allocation in the Intrepid Disciplined Value Investor Fund (ICMCX), on which Mr. Estes is the lead manager.

“It's frustrating to have that much cash in a market like this, when everything has been on such a tear,” he said. “But we make no apologies to our investors because we know the markets don't always go up, and they turn very unexpectedly.”

Across the mutual fund industry, the average cash allocation, according to Morningstar Inc., doesn't appear wildly out of line with previous market cycles, but averages can mask a lot of extreme activity. At the end of October, the average U.S. equity mutual fund had a cash weighting of 3.7%, which compares with 4.2% at the end of 2011, and 3.6% at the end of 2006.

But what a Morningstar search also uncovered is that there are at least a dozen mutual funds with cash allocations in excess of 50%.

At 64.7% in cash, Eric Cinnamond, manager of the Aston/River Road Independent Value Fund (ARIVX), acknowledged being “extremely frustrated,” but believes he is doing the right thing for investors in his fund.

“Patience, I believe, is one of the most important characteristics of successful investing, but that is difficult in our industry because it requires benchmark tracking error and career risk,” he added. “This industry has weeded out most of the people like me, and we're almost extinct, but I believe it's our fiduciary duty not to overpay for stocks.”

Mr. Cinnamond recalled building up a 50% cash position leading up to the stock market's peak in 2007, but said the current cash level is higher than he has ever had in 15 years of managing the strategy.

“We're a small-cap manager and this is the most expensive small-cap stocks have been in 20 years,” he said. “Investors are assuming this isn't a peak and that's the only way to justify these levels, but we're saying that there is another recession coming and profit growth will decline.”

Todd Rosenbluth, director of mutual fund research at S&P Capital IQ, said the increased allocations to cash have become more prevalent among value strategies, but he added that the safety of cash could also have something to do with locking in gains for the year.

“The average equity mutual fund has gained 30% so far this year, and with gains so high, some managers don't see any reason to chase performance to try and look even better by the end of the year,” he said. “Some managers might see the market as being frothy right now, but all managers might not be looking at the same time horizon.”

Mr. Rosenbluth added that when it comes to cash balances, it is also important to consider a fund's turnover rate.

“Managers with lower turnover will tend to let stocks run a bit longer, while higher-turnover managers will be more likely to take profits, and sit in cash and wait,” he said.

The S&P 500 has gained 28.9% so far this year, still below the 34% gain of 2009, but that was an example of extreme rebound performance following the 38% decline in 2008. This year's market performance is following a very respectable 15% gain in 2011.

“We still think there's room for growth in the stock market, but we would also acknowledge a very strong run, and it will need fundamental improvements in the economy to drive stocks higher,” Mr. Rosenbluth said.

All actively managed mutual funds hold some cash, which is necessary and responsible to help meet redemptions and take advantage of new investment opportunities. But when cash levels get disproportionately high, investors often begin questioning why they're paying an active manager to sit in cash.

“As a portfolio manager, people don't give you money to hold it in cash, and if you're holding a lot of cash, you're not necessarily doing what investors think you should be doing with their money,” said Bill Mann, chief investment officer of Motley Fool Funds.

On the above-average 10% cash allocation in the funds he oversees, Mr. Mann explained, “It's a valuation call, and a little of an outcome of our investment process.” The last time Mr. Mann was in the 10% cash range was during the peak of the Greek financial crisis in early 2011.

“Cash is us refusing to invest where we have a potential for a negative risk-adjusted return,” he said. “It means we're really struggling to find something at a good price.”


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