Should Funds Be Allowed to Go to Cash?

Many of the funds that have held up the best during this brutal market have one thing in common: cash.

The international-stock leader board for 2008 offers perhaps the clearest example.  First Eagle Overseas (SGOVX) had among the mildest losses of any international fund, and it had a double-digit cash stake.  Third Avenue International Value  held its loss far below its category average, and its cash level was still in the midteens at midyear even after it deployed a bit of its cash hoard to buy a few bargains.  UMB Scout International  recently let its cash rise to 15%, says manager James Moffett. That fund was in the foreign large-blend group's top decile in 2008.

On the domestic-stock side, a glance at the 2008 leaders' list also shows a large percentage of funds with substantial cash stakes.  Tweedy, Browne Value (TWEBX) and  Yacktman Fund (YACKX) are just two examples.

Of course, having a meaningful cash stake didn't guarantee that a fund would post a milder loss. Conversely, some fully invested portfolios outperformed. Still, it's noteworthy how many of the better performers had a cash cushion. Not that it's surprising that funds with money stashed on the sidelines would have an advantage when markets plunged. Rather, the reason it catches one's eye is that most funds aren't allowed to take that course. Most stock-fund managers are required by their firm to be fully invested, or fairly close to it, at all times. Now is an opportune time to ask: Is that a good idea?

Hey, That's My Job
It's no secret why most funds stay fully invested even if their prospectus technically allows some leeway: Investors want it that way. Most investors, at least. The idea is that investors have made a choice to own a particular type of fund and can decide for themselves whether to stash a separate amount of money in a cashlike alternative such as a money-market fund or Treasury bills. Financial advisors, in particular, take the view that asset allocation is their role, and fund managers shouldn't complicate that effort by holding cash of their own. In fact, even if a manager's bosses don't explicitly limit cash stakes, it wouldn't be surprising if the manager takes that course anyway after hearing from shareholders.

When markets are rising, this system works fine. Everyone wants his fund to be fully invested. The few funds that aren't often have shareholders that understand the manager's idiosyncrasies and are willing to live with underperformance during rallies. They expect they'll be glad when times get tough, and that over the long term the manager's cautious streak will pay off. Those shareholders who don't fit that pattern tend to sell such funds when they don't keep up with a rising market.

When stocks are falling, though, the issue gets murky. That's especially true if a manager has been expecting problems in the economy or the market, and said so. Some shareholders might ask: Why didn't you protect me, then? The honest answer might be, You didn't want me to. But would it be preferable to allow managers more discretion?

It's not a theoretical issue. Take Rudolph-Riad Younes of  Artio International Equity (BJBIX) and  Artio International Equity II (JETAX). (Note: Both funds formerly carried the Julius Baer label). For years, he has been warning about dangerous "imbalances" in the global financial system. He was particularly worried about the problems caused by the excessive borrowing spurred by very low U.S. interest rates and the fact that accounting methods were overstating corporate earnings. By midyear 2008 he and comanager Richard Pell had let the funds' cash rise to about 10% of assets, unusually high for these funds. By October it was 18%. (He says the cash stake is now down to about 5%.)

The cash stake wasn't large enough, or at least the sharp increase in its size didn't come early enough, to prevent deep absolute losses. Some of the stocks that Younes bought with the hope that they'd be relative safe havens got hit hard. Artio International Equity lost 44% in 2008, and Artio International Equity II lost 40%. But the latter fund's return did beat the MSCI EAFE Index and nearly 90% of its foreign large-blend rivals. Without the cash, it's almost certain the damage would have been more severe.

No Complaints Here
As a shareholder of Artio International Equity II, I'm glad to give the Artio managers such freedom. Younes and Pell have a long record of success with a strategy that involves a lot of macro forecasting. I have felt the same about First Eagle Overseas, which I have owned for many years. When that fund's value mavens couldn't find enough companies in the world that met their cautious standards, I preferred that they stand aside rather than fill up the portfolio regardless.

That said, readers will no doubt point out three reasons that these examples may not have wide application. First, the long-tenured managers of the Artio and First Eagle funds are exceptional. Most managers can't boast anything close to the records amassed by Younes and Pell or First Eagle's Jean-Marie Eveillard. (Unfortunately for shareholders, Eveillard soon will step down from his manager post.) Second, my situation is not typical. As a Morningstar mutual fund analyst, I've had the opportunity to gain familiarity with these managers, and confidence in their strategies, through extensive research and contact, including personal interviews over a number of years. Most investors don't have the benefit of that access or the time to do as much investigation. 

Third, I recognize that it's easy to proclaim the glory of cash stakes after the market has suffered a historic meltdown. It's a tougher call when everything seems to be going up.  

That's why I'm raising the question of whether more flexibility would be preferable, but not claiming to have a definitive answer. For one thing, I don't think that we can count on all managers to use such freedom wisely. Some would be tempted merely to market-time, with unpleasant results. Also, most advisors likely would object to granting wide latitude to fund managers. And for good reason: When they say allocation is their territory, that's not just an instinct for self-preservation talking. It's true, as they argue, that dedicated and responsible advisors know their clients' circumstances, preferences, and overall portfolios much better than a distant fund manager could.

Therefore, the issue isn't whether to let all managers have total flexibility. Rather, it's whether the bonds (no pun intended) should be loosened and to what degree. Are advisors willing to let managers have more freedom if they truly can't find enough stocks that meet their strategy or if they are convinced that the market is headed for a fall? If so, how much leeway should a manager get?

What Do You Think?
I'm curious about your opinion. Are you more willing to allow a manager to let a cash position rise than you used to be? Or do you think that a manager's job is to fill the portfolio to the best of his or her ability, keeping only the minimal cash position required for practical purposes? If you want to allow a larger cash position, how much is reasonable? Does the answer depend on whether the fund is a broadly focused fund or a narrowly targeted sector or country fund?

Don't forget that at some point the market is going to rise. (At least we hope so.) So, the answer has to apply in that circumstance, when cash will probably be a drag on returns, as well as in today's gloomy environment.