Value Managers Keeping Some Powder Dry

One good test of active fund managers is whether they have the courage of their convictions, even when they lead in a different direction than their peers. Investors who choose actively managed funds typically do so because they want the person investing their money to have a deep understanding of the market and great instincts, knowing when to zig while others mistakenly zag.

A lot of attention is paid to where in the market a fund manager chooses to invest, but far less is paid to the decision about how much to leave in cash. Keeping money on the sidelines can be an important element of a value manager's strategy. Doing so has an obvious potential upside: plenty of liquidity available for jumping on a great opportunity, or protection if one expects the market to take a dive. But of course there's a downside, too, namely the opportunity cost of not having the money in the market at a time when it would have appreciated in value.

The fund manager must weigh these potential outcomes along with several other factors: an assessment of current stock valuations versus risk, composition of the rest of the fund's portfolio, and so on. For investors, another consideration is whether a manager should have the leeway to keep a substantial amount of fund assets in cash if he or she thinks it best. Some fund companies require that managers keep a portfolio close to fully invested. After all, if investors wanted their money in cash, they'd have done it themselves, the thinking goes. But for those who prefer to invest with managers who have more freedom to hold cash--and were recently doing so--we've used Morningstar's  Premium Fund Screener tool to find value funds with substantial cash positions.

As of the end of March, the average large-value fund held 2.35% of assets in cash, the average mid-cap value fund held 3.34%, and the average small-cap fund held 3.54%. We screened on value funds with at least 7% in cash (so at least double their category averages) to highlight those that are particularly willing to keep money on the sidelines. Bear in mind that the market was much more close to fairly valued at the time, according to Morningstar estimates, so cash percentages might have shifted during the recent market decline. We stuck with no-load funds and excluded institutional offerings and funds closed to new investors. Finally, we screened on just those funds vetted by Morningstar's fund analyst team and given Morningstar Analyst Ratings of Gold, Silver, or Bronze. Premium Members can see the full screen by clicking  here. Below are three of the funds making the cut.

 Appleseed (APPLX)
Cash: 10.8%
Aside from its sizable cash position, this small ($238 million in assets) mid-cap value fund is heavy on consumer stocks, which make up more than 40% of its concentrated portfolio, and has about 30% of its holdings in overseas stocks. It's a socially conscious fund, meaning that it screens out alcohol, tobacco, gambling, weapons, and pornography stocks, along with--as of 2010--"too big to fail" banks. Managers emphasize downside protection and had more than one fourth of assets in cash and gold at the end of 2011. The fund finished in the top 1% and 3% of mid-cap value funds during the market downturn of 2008 and 2009, respectively, before plummeting to the bottom 1% during the market rebound of 2010. 

 Vanguard Selected Value (VASVX)
Cash: 7.7%
The fund's management team takes a two-pronged approach, looking for stocks with above-average yields selling at below-average valuations on one hand while also looking for those with low price/book ratios on the other. The latter method, in particular, can lead to buildups in cash when stocks meeting managers' criteria are harder to find. The portfolio has a slight tilt toward financial-services and industrials stocks, and the fund has been in the top third of mid-cap value funds in annual returns during the trailing one-, five-, and 10-year periods. Expenses are low (0.45%) for an actively managed fund in this category.

 Yacktman (YACKX)
Cash: 12.2%
This large-value fund's management team runs a highly concentrated portfolio and isn't afraid to keep assets in cash if it doesn't see opportunities. They like companies that have strong cash flows and low debt and that sell at discounts to what they think the companies are worth. Consumer stocks make up more than half the portfolio, with technology another emphasis at around 16%. Top holdings include  PepsiCo (PEP) at 9.4% of the portfolio and  News Corp  at 8.1%. The fund has been an exceptional long-term performer, with three-, five-, 10-, and 15-year annualized returns in the top 3% of its category or better. 

Portfolio data as of March 31; performance data as of May 21.