Kinnel: 3 Fund Picks That Hold Sizable Cash Stakes

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the equity market rally entering its eighth year, some investors might naturally be attracted to a mutual fund that holds some dry powder. Joining me to discuss this phenomenon and share some funds that do hold a lot of cash is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: Russ, let's talk about this phenomenon of mutual funds holding cash. It seems to kind of swing in and out of favor depending on what the market is doing. But let's talk about why fund managers might hold cash at all. Does it tend to be the more valuation-sensitive managers who, when they can't find enough to buy, will let cash build up? What are the major motivators for holding cash?

Kinnel: The vast majority of equity managers really are not going to hold cash. So, you don't want to expect them to in the next bear market. But there are some value-oriented managers and some focused managers who will hold cash either as a reflection of the fact that they can't find something to buy and they want to stay true to their discipline, or some will own cash just to be defensive. And it's not a bad thing if you have a focused portfolio because it can mute a little of that risk.

Benz: I know some investors are of two minds on this idea. On the one hand, some investors might like the idea of a fund that might have some defensive qualities and perform a little better on the downside. Other investors, and we maybe hear this more from financial advisors, say, well, I want to be in charge of the asset allocation decisions for the portfolio. I don't want my manager making these decisions on my behalf. How do you think fund investors should think about this question?

Kinnel: Yeah. I don't think you would want an entire portfolio of managers who could swing largely into cash, but I think if you've only got one or two of those, I think it's absolutely fine provided those managers are doing so in a disciplined way, provided their track record indicates that they can use that cash well.

Benz: Should I ever be concerned if I see an enlarged cash position in my fund? Are there situations where you would consider that kind of a red flag or something that you wouldn't want to see?

Kinnel: Well, I guess, I might be a little worried if say--let's go back to '08-'09--if the manager were fully invested in '08 and then say June '09 after the market had hit bottom then they started to move to cash, that would bother me a lot. But generally, I don't think I would worry too much as long as that's within their discipline. And as you pointed out, today, we are eight years into a long rally. I'm really not going to begrudge a manager a higher cash stake today.

Benz: OK. Let's talk about the performance pattern for funds that tend to hold cash. They sometimes underperform on the upside. So, during the current rally, for example, some of these funds have underperformed. But you think that they tend to kind of earn their keep in market sell-offs.

Kinnel: That's right. Over a full market cycle, this strategy can work well. But some of those funds are lagging over the recent five years because the market has been going straight up just about. But I think it's OK as long as you understand the value proposition is, over a full cycle you want to get pretty good risk-adjusted returns from a good fund like this.

Benz: So, you brought a short list of some funds that you and the analyst team like that currently hold sizable cash stakes. In the case of two of them, they more or less frequently hold large cash stakes. The other one's cash stake is large relative to its historic pattern. Let's start with IVA Worldwide, talk about that fund, talk about its cash positioning, and let's talk about why we like the fund.

Kinnel: That's right. This fund's orientation has always been about absolute returns, protecting against big losses and then more sort of treading water with the competition in rallies. The fund currently has its cash stake all the way up to 42%. As you said, they consistently have a fair amount of cash, but now they are really at the high end. Clearly, they seem to not be able to find much to buy, they seem to be pretty wary of the markets look right now.

Benz: OK. Let's take a look at AMG Yacktman. I know that this is a fund that's on a lot of our Morningstar.com readers' radars. Let's talk about it. You say that its large cash position is getting to be kind of a permanent condition for the fund. Let's talk about that.

Kinnel: That's right. The last time they really got fully invested was in the wake of a bear market, so '09 they got just about fully invested. Today they are about 20%, and that's not uncommon for them. And you can see that that cash has been a bit of a drag. The five-year returns are not great relative to the peer group. But again, that's how they do it, and they are very disciplined value investors. And so, I think, that's absolutely fine the way they do that. The cash offsets some of the fact that they are a pretty focused portfolio. And so, I think, it's absolutely fine the way they do that. I wouldn't mind owning a fund like that today, again, because the markets have gone up so much.

Benz: OK. So, IVA Worldwide, the first one you talked about, that's a world-allocation fund. AMG Yacktman is in our large-cap blend category. The third fund, Invesco Diversified Dividend, this is a large-cap value fund. This is one where you say its cash position is pretty large relative to where it's ever been. Let's talk about that fund.

Kinnel: That's right. If you look over the history of this fund, it's generally pretty close to fully invested, say, 5% or less in cash. But today, it's all the way up to 18%. That really jumped out at me. Meggan Walsh has done a great job at the fund. We rate it Silver. And it's got a dividend focus, but also a value orientation. And they've indicated that they are just not finding that many names to buy these days. So, cash has gone up. I wouldn't expect it to be a long-term move, but it's really an unusual move because you don't see a lot of funds like that that are generally fully invested moving into cash that way.

Benz: OK. Last question for you, Russ. I know in the past we have sometimes seen funds holding a lot of cash, and if it's coincided within an enlarged asset base that that has sometimes been a little of a red flag that it looks like the manager is maybe taking in more money than he or she can put to work. Is that a risk factor that investors should keep an eye on if they see their fund suddenly has an enlarged cash stake and that really hasn't been part of its M.O. in the past?

Kinnel: For sure. You want to look at flows. Have flows really gone up and how long are they holding that cash? So, let's say, they had a spike in flows, are we talking about a couple of months of a big cash position or is it really a longer-term issue, in which case, that kind of indicates, well, if you couldn't find anything to buy then why aren't you closed to new investors?

Benz: Right. Well, Russ, thank you so much for being here to discuss these funds and this phenomenon of funds holding cash.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.