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To Cash Or Not To Cash?

| 4/19/2012 9:00 PM Thursday

Cash holding in equity mutual fund is a very critical aspect and the level of cash with any asset management company reflects among other things the stock-picking skills , market-timing abilities, the investment opportunity set of the manager, and expectations about liquidity needs of the fund. What is perplexing and mystifying is that equity mutual funds pursuing the same objective tend to hold cash of different levels, as logically they should be holding the same cash level. For example BNP Paribas Midcap has a cash holding of 7.03 per cent compared to HDFC Mid-Cap Opportunities Fund that holds 3.61 per cent of its asset under management at the end of March 31, 2012 in cash. In a study done by Morningstar India, fund houses like Escorts, Reliance, Sahara and Taurus are known to have kept more cash, with cash holdings in excess of 20 per cent on many occasions. Such excess cash holdings were mostly held in the period of 2008-09, when the financial crisis was underway and there was uncertainty regarding the future flows. On the other hand, fund houses like Fidelity, Franklin Templeton, HDFC and Tata have maintained lower cash holdings, in the range of four to eight per cent, over the past five-year period, across most of their funds. What are the reasons for such differences and the effects they have on future fund performance?

Equity mutual funds hold cash for several purposes. First, funds hold cash to meet unit holders’ redemption needs. Second, funds use cash to pay management fees and other expenses, and to pay dividends and capital gain distributions. Third, fund managers may hold cash when they expect future stock market returns to be low. However, these cash holdings have their own cost. The most important among them is the opportunity cost and hence they tend to be a pull on long term fund performance. Therefore, there is a trade-off between the costs and benefits of funds’ cash holdings. Funds that give optimal returns are the ones that set the fund’s cash holdings at a level such that the marginal benefit of cash holdings equals the marginal cost. The trade-off is between two factors, the expected trading cost of liquidating stocks to meet redemptions and the opportunity cost of cash.

Other factor that plays an important role in determining the cash level of any fund is its category. It has been observed that large cap funds hold less cash compared to small or mid cap oriented funds. The reason for such difference is the higher liquidity of large cap stocks, which gives the fund manager a leeway to generate liquidity as and when required by selling stocks with a minimum impact cost. Whereas for the small or mid cap funds sometimes the fund manager has to incur relatively large impact cost to get liquidity. It has also been observed that prices of mid cap stocks are more volatile and these shares would result in the prices zooming up due to any sudden demand or fall in the prices due to any event. Hence it has been found that performance of the funds holding more cash in the same category; that is, either lager cap or small cap stocks have underperformed a tad lower than the funds holding lesser cash.

Therefore, investors should pay close attention to the cash holding of the schemes in which they are going to commit their fund as it will play an important role in determining the future performance of the fund.

 

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