There are some funds (like value funds for instance), that opt for the mandate to hold a significant portion of their portfolio in cash. The intention is to invest only in stocks that meet their pre-determined investment criteria. And in rising market conditions, when funds fail to unearth stocks of the aforementioned variety, they choose to hold a portion of their portfolio in cash.

If the markets move northwards, expectedly a fund heavily invested in cash will trail peers that chose to be fully invested in equities. While you are likely to be tempted to give such a fund the thumbs down for its poor showing despite the rising markets, it actually deserves commendation for having adhered to its investment mandate. Hence, it is pertinent that you appreciate the rather unique investment proposition offered by such funds, before getting invested.

2. Anticipation of market volatility

Don’t be surprised if you find that a fund which is generally fully invested in equities, suddenly opting for a sizeable cash holding. More so, if a similar investment strategy is being adopted by several fund houses, around the same time. There’s a fair chance that some fund managers have foreseen a volatile phase in equity markets and fortifying their funds to deal with such a scenario. Should a volatile market phase follow, funds with significant cash allocation will be better insulated against the volatility vis-à-vis peers that are fully invested in equities.

3. Providing for a forthcoming dividend

It is not uncommon to find equity funds building their cash reserves before declaring a dividend. Depending on the size of the fund and the dividend to be declared, this exercise is typically conducted over a few months. On a different note, such a change in the fund’s portfolio is often used by mutual fund distributors and advisors to entice investors to get invested in anticipation of the forthcoming dividend. Of course, the dividend is declared from the fund’s net asset value which falls consequently.

4. Coping with redemption pressure

A fund faced with consistent redemption pressure is likely to maintain higher-than-average cash levels in its portfolio. The redemption pressure can be triggered by various reasons – both internal and external. For instance, poor performance, exit of a star fund manager who was at the helm of the fund or even an uncertain market scenario. Irrespective of the reasons for the exodus of monies, the same could adversely impact the fund’s performance if quality stocks are sold prematurely to cope with the redemption pressure.

5. Investment philosophy

At times, a fund’s investment philosophy dictates its cash allocation. For instance, there are funds that chose to be fully invested in equities at all times, irrespective of market conditions. And then there are those who chose to make a healthy allocation to cash at all times (although such funds are rare). The intention is to have a ready buffer, which can shield the fund’s performance from market volatility, even at the cost of performance. Only, in the rare case of an extremely attractive investment opportunity presenting itself, the fund chooses to be fully invested in equities.

The above list is not a comprehensive one. The possibility of an equity fund holding cash in its portfolio for reasons other than the ones mentioned above or on account of a combination of several reasons cannot be ruled out. At all times, the key lies in being aware of the reasons behind an equity fund’s cash holding and their implications.

Information Source: http://www.personalfn.com

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