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These Fund Statistics Are Broken as Indicators

For mutual funds, cash is...cash.

Russell Kinnel, 03/25/2008

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

Looking for answers about where the market is headed next? Don't look at mutual fund data. It would be nice if this data could tell us whether a tidal wave of new money was going to hit Wall Street or whether jittery investors would pull their money out, but it doesn't work that way.

The most commonly sited data from mutual funds I see being used to get sense of where the market is headed are net inflows and mutual fund cash positions. Unfortunately, the first gauge is a lagging indicator and the second hardly ever changes.

Is There a Cash Hoard?
There have been some reports that money managers have built up cash and that they are waiting to invest that at lower prices. That may well be true, but it isn't in the mutual fund world. Once upon a time, mutual funds were run like they were an investor's only holding; some managers liked to try to time the market by building cash when the market was overpriced and investing it when things looked better.

However, that's not how things work any more. Most fund companies and many investors expect their managers to be fully invested. At Fidelity, for example, they look at a fund's history of sales and redemptions, its asset size, and its volatility to estimate a likely range of possible inflows and outflows. The fund then targets a cash range that can accommodate that--say 3% or 4% commonly. Other fund shops aren't quite that strict but it's pretty rare that you see managers making double-digit moves into cash.

I've seen some reports about heightened cash positions in funds but that's a little misleading. There are a number of funds that invest in futures or other derivatives and hold cash against those contracts. In that case, the cash isn't free to be invested when the manager feels bullish--it already is invested. To see what the typical U.S. stock fund's cash position is, I screened out balanced funds, long-short funds, and funds from fund companies that typically hold derivatives so that the cash stake is misleading (PIMCO, Profunds, Rydex, and Direxion). Adjusted that way, cash is just 3.7%. That's fine for meeting redemptions, but it isn't exactly a hoard waiting to buoy the market.

One downside of staying fully invested is that a manager might have to make more flow-driven trades, and that can be pretty costly according to recent academic research. As a result, some funds use ETFs as a way to gain market exposure but in a very liquid way so that they can sell or buy more to meet cash while staying fully invested.

Have we lost something by having managers stay fully invested? I don't think so. In order for strategic cash to be a useful tool, the fund should meet two tests. First, the manager should be good at using cash either as a macro call or as a reflection of opportunities the manager is finding as you see at places like Longleaf, Fairholme, and FPA. Second, it should be clear to shareholders that the fund will make such moves into cash. Not many funds meet those criteria. I have no problem with those that do; its hard to argue with Longleaf's approach or results, for example.

Moreover, funds stay fully invested because advisors can do a much better job of allocating cash for their clients than a manager can. Advisors can design allocations that suit their clients. In addition, cash in a money market fund is readily accessible in case of emergency or the need for a big purchase whereas you can't exactly tap cash in a stock fund. It could be way down when you need that cash or it could be way up and you'd have to pay taxes if you redeemed.

Fund Flows Tell You Where You've Been
What about fund flows? Unfortunately, fund flows are a lagging indicator. Want to know where the market has been the past two or three years? Great, then flows are your answer.

Let's go back to the beginning and end of the bear market of 2000 and 2002 to see what happened. In 2000, when the bubble burst, we saw massive inflows of $388 billion as a strong economy and wacky market sustained investment even as the market moved lower. In 2001, inflows surged to an all-time record of $504 billion! There was a general expectation that the economy and markets would rebound--until the attacks of September 11 when that changed dramatically. In 2002, net inflows dipped to $74 billion though that would have been the best time to buy. In 2003, when the markets snapped back brilliantly, fund suffered net redemptions of $43 billion.

In short, flows might work as a nice contrary indicator but they certainly don't drive the market or predict where it's headed. While the trend partly reflects a sorry inclination to chase performance, it also simply reflects how much money people have to invest. After all, the bear market overlapped with a recession and investors just had less to invest, too. As we appear to now be in a recession, I'd expect flows into mutual funds to grind lower for the rest of the year. No idea what that means for the market, though.

Russell Kinnel is director of mutual fund research with Morningstar.

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