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Over Exposure?


Just keep the money comin', guys.

A couple of days ago, the Investment Company Institute, a group that tracks the mutual fund industry, released its latest industry statistics which covers the period through the end of January.

One of the more widely-watched metrics from the Institute is the percentage of portfolios that fund managers allocate to liquid instruments such as cash. This level has been watched for decades as a reflection of sentiment on the part of fund managers.

I've discussed before that short-term interest rates have an inordinate impact on fund cash levels (after all, if a money market is yielding 8% or 10%, why risk capital in equities?). When we adjust the cash figure for the current level of rates, we can perhaps get a better feel for whether fund managers are overly optimistic, or if they just have few other alternatives for investment.

The chart below shows a snapshot of this "cash surplus or discount" over the past 30 years. When the blue line in the chart is high, it tells us that fund managers are holding more cash than they "should" be given the level of short-term rates at the time. When it is low, it tells us that the managers are holding less cash than they should be.

As of January, we figure that funds have about 1.4% less cash on hand than they should have. The figure has certainly been more extreme (witness the year 2000), but when we get to 1.25% or so away from the expected level of cash, we begin to see an effect on future market performance.

When funds have held 1.25% or more surplus cash, the S&P went on to enjoy an average gain of 13.8% over the next 12 months, with 84% of them being positive (using data since the 1950's). However, when they were in a cash deficit of 1.25% or more (as they are now), the average 12-month return falls to a middling 0.6%, and there was only a 50/50 chance of seeing a positive return.

We are not yet seeing a "sell" signal based on this data, but it is marching closer. As short rates move higher, fund managers are not increasing their cash reserves. There are a whole host of reasons for this, but generally we would much prefer to see fund managers exercise some caution as opposed to being nearly fully invested.
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