Perspectives from ISB

This article was first published in the Economic Times, April 12, 2012; Co-Author: Dhruva Raj Chatterji, Morningstar India

The debate over the benefits of large cash holdings by actively managed funds has been ongoing since a long period of time. In India, fund houses like Escorts, Reliance, Sahara and Taurus are known, within the industry, to take cash calls from time to time, with cash holdings in excess of 20% on many occasions. It should be noted here that the excess cash holdings played out mostly in the period of 2008-09, when the financial crisis was underway- taking its toll on markets. Post that period, cash calls by most funds have tempered down substantially—but then again, so has the adversity in stock markets. On the other hand, fund houses like Tata, Fidelity and HDFC have maintained lower cash holdings, ranging between 4-8% over the past five- year period, across most of their funds.

What we are trying to find out is that, do the equity funds in India observe better performance when holding higher cash (especially during the market downturns); or do they end up missing out on sudden upturns in the market. In other words—is there a difference in the performance of funds with higher cash holdings, versus those with lower cash holdings, within the Indian markets?

Taking two categories of equity funds, Large Cap and Small & Mid Cap, we compare the highest cash holding funds with the lowest cash holding funds (See Table). In the case of large cap funds, the top 20 funds with high cash holding funds, hold about 9% more cash on average, than the bottom 20 cash holding funds over the past five years,  but have earned about 1.2% lower returns (annualized) than them, over the same period. The performance is particularly poor over a 3 year period, where their returns are about 7% lower than those funds with lesser cash holdings, within the large cap category.

We find a similar pattern in the case of Small & Mid Cap funds, much starker though. It seems that the top ten funds with the highest cash holding within this category, earned almost 5.5% less (annualized) than the bottom ten funds with lower cash holding, over a five year period. Over a three- and one-year period, they earned approximately 10% (annualized) and 6% lesser, respectively.

Our analysis shows that cash clearly plays an important role, especially in the case of Small and Mid Cap funds. The reason for this clearly lies in the category of funds. Large cap funds, by virtue of investing in large cap, liquid stocks, are able to buy and sell the shares quickly and hence the role of cash while timing the market becomes less important.

On the other hand, in the case of small and mid cap funds, keeping excess cash might mean losing out on an upswing, as the lower liquidity would result in the prices zooming up due to sudden demand. The vice-a-versa is also true. That is, in the case of illiquid stocks, selling might not be easy when there is a redemption pressure or a downturn. This probably explains the higher historical average cash holdings, of mid cap funds, when compared to their large cap peers.

However, we are surprised by the fact that the funds in India behave quite the opposite of the funds in the US, with respect to the cash holdings. In a study done by Mikhail Vasilevich Simutin, of the University of British Columbia, in 2010, it was found that in the US markets, higher cash holdings result in better future performance by the fund.

Cash holdings play a very important role in timing the market and reflect upon the stock picking abilities of the fund managers. Mikhail (2010) points out that “Cash tends to earn a lower return than equities, and therefore unskilled managers may prefer to remain fully invested in stocks to attempt to match benchmark returns. On the other hand, a skilled manager who cannot presently find any attractive investment opportunities may carry a higher cash balance. In the future the manager will invest the excess cash as such opportunities become available”.

While this seems to be true in the US context, in India, we notice that holding higher cash —increases the risk of deploying it at the right time. The fund managers often miss out on a sudden upturn, as is evident from the graphs below for large cap funds and mid cap funds. Clearly higher cash holdings have resulted in lower fund returns in the following months, especially when the markets have turned around very suddenly (sudden upturns). Again, here the impact seems to be starker within the small/mid cap fund category, where there are instances when the funds with high cash holdings have underperformed those funds with lowest cash holdings, by more than 3% (on average) in the following month.

On a closing note, besides the cash holding, there are other important factors too, which have a bearing on the performance—like the quality of the fund management team, the processes in place etc. However, avoiding high cash calls, and remaining more invested across market cycles, does point towards a more disciplined approach towards investing. Moreover, it helps to neutralize the risk of being caught on the wrong foot, especially in event of a sudden upswing in markets. After all, one maybe able to time a cash call correctly a few times here-and-there, but to get it right consistently is quite another ball game. As legendary investor/fund manager Peter Lynch once said—”Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”