Why high cash calls could be a double-edged sword for fund managers

The bottom line is whether the fund manager has been able to generate alpha with this strategy

The Nifty’s sharp turnaround — rising 895 points or 8.4 per cent — over the last two trading days (Friday and Monday) has suddenly changed the narrative for stock market investors. Just a week ago, many were celebrating fund houses that were sitting on high cash to protect the investor from losing more money.

Due to the sharp movement in a very short time, any equity fund manager who had gone heavily into cash to protect himself against the market downturn would have missed out on these returns. These events raise the question whether investors should invest in funds that take high cash calls.

Most funds maintain an exposure of 1-5 per cent to cash to meet redemption requirements. Sometimes these levels rise to 5-10 per cent. “Cash levels may have risen in recent times because markets have been choppy and fund managers kept higher cash levels to take advantage of buying opportunities that could arise. Besides, in categories like mid- and small-caps, fund managers take more stock-specific calls and hence wait to buy the stocks they like at desired valuations,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India. Liquidity is an issue in these categories, so fund managers deploy cash gradually to minimise impact cost (which refers to an investor’s own purchases driving up a stock’s price, thereby raising his average buying cost).

In falling markets, some fund managers deliberately move a portion of their portfolio into cash because this helps them beat their benchmark and peers (by declining less). The flip side of such a call is that when the markets run up, a fund manager who is heavily into cash gets left on the sidelines and subsequently struggles to catch up with his fully-invested peers. “Historically, the experience has been that it takes time for the markets to fall to lower levels. But upward moves tend to be very sudden and sharp,” says Gautam Kalia, head, investment solutions, Sharekhan by BNP Paribas. Thus, if the expected returns from equities are, say, 12-14 per cent in a year, and a fund manager is out of the markets on those two days when it generated an 8 per cent return, he will have a difficult time catching up.

This has happened in the past too. Many fund managers were caught on the wrong foot in 2009, when the markets rebounded after a very bearish 2008. Since then, many fund houses have put in place internal stipulations requiring fund managers not to exceed a 5 per cent cash level.

Another argument against high cash holdings is that the investor pays the fund house an expense ratio for investing in equities. The asset allocation decision should be taken by the investor or his advisor. If the fund manager decides to go heavily into cash, he skews the investor’s asset allocation. Thus, by and large, it works in the investor’s favour if funds remain fully invested.  

But what about funds like Quantum Long-Term Value Equity that go into cash levels up to quite high levels (and yet it has given a 12.28 per cent compounded annual return over the past 10 years)? Says Nilesh D Shetty, associate fund manager-equity, Quantum Mutual Fund: “We follow a process-driven approach. We have buy and sell limits for each stock in our universe. In a bull market, the sell limits of a lot of stocks get triggered. The fund manager then has no option but to sell those stocks. If valuations are expensive and the buy limits of very few stocks get triggered, and the fund also receives inflows, then the cash level tends to rise.” High cash levels, however, allow the fund to deploy money in the ensuing correction at more attractive valuations.

Should investors then take an exposure to funds that take high cash calls? Says Kalia: “Check if this strategy has helped the fund manager generate alpha over the long term. Also, see whether the fund house has communicated its mandate of taking high cash calls clearly to investors.”