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Fund Cash and Rates


I forgot about that!


A topic I've seen discussed with increasing frequency lately is that of the amount of cash held by mutual funds. Taken as a percentage of total assets, as of December the average fund held only 4.3% of its assets in cash. This is of concern for a couple of reasons, with the most common argument being that if funds begin to get a large number of redemptions from investors, and they have a minimal amount of cash on hand, then they will need to sell stock in order to meet their cash needs, fueling the market decline that is most likely the reason for the redemptions in the first place.

A cash level of 4.3% is extremely low historically, as it is in the bottom 2% of readings since the 1950's. Other than February 2003, the other recent times cash has been so low were March 2000 and April 1998, after which the market had...ahem..."difficulty" moving to the upside.

As with many topics, however, there is a "however". When short-term interest rates are high, mutual funds have something of an incentive to hold cash. If you are a fund manager, and there is a risk-free investment that will give you a 10% return, are you going to put your money there or are you going to risk it in the stock market? Most of us would surely switch to the risk-free opportunity, which I am defining as 90-day Treasury Bills.

This logic certainly is supported by the numbers. The correlation between mutual fund cash levels and 90-day T-Bills is 0.74, which means that the prevailing level of interest rates can theoretically explain 55% of why mutual fund cash levels are where they are. So with short-term T-Bills now yielding under 1%, what incentive is there for mutual funds to hold a lot of cash (other than meeting redemptions and the risk of straying too far from their charter)? If we take a simple difference between prevailing interest rates and mutual fund cash levels, then we can see the interaction between them.

This paints quite a different picture. We can see from the chart above that in 1998 and 2000, mutual funds had cash levels that were actually BELOW the rate on 90-day T-Bills. Currently, however, funds are holding cash at a level that is quite high historically, given the level of short-term interest rates. Granted, it would be mighty difficult for a fund to have less than 1% of its assets in cash, which is what we would need to see now in order to get this cash premium below zero.

If we look at how the S&P 500 has performed after various levels of this cash premium, a definite pattern emerges. Barely 50% of the time, the S&P was higher one year after the cash premium went below zero, which is well below a random period. However, when the cash premium was at 3% or greater (which it is now), then the S&P was higher one year later 79% of the time, which is well above a random period.

Taking a simple difference between cash levels and interest rates is just that - simple - and somewhat misleading. Using a more sophisticated approach leads to the conclusion that if interest rates were at 0%, then funds would normally hold 4.55% of their assets in cash. So, we can then subtract the current cash level from 4.55% and get an idea of how optimistic or pessimistic fund managers may be without the distorting effects of interest rates. Doing this improves the forecasting ability of the fund cash levels by a large amount, so it is worth the effort. Using this approach, we conclude that funds are holding about 0.71% less cash than they "should" be given the rate on 90-day T-Bills. This is about average since 1954, meaning that it appears as though funds are holding neither "too much" nor "not enough" cash at the moment.

This is most certainly not a perfect market timing mechanism, and I would never recommend that anyone base trades solely off of data like this. Monitoring these cash levels does improve our chances of forecasting future market performance, however, so it should be watched. I agree with the logic that low absolute levels of mutual fund cash are troublesome - market history supports that argument. But I don't agree with the assumption that cash is low because fund managers are too optimistic on the market - I believe there are simply too few alternatives giving them the opportunity to earn acceptable yields for their investors (from their perspective).

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