Why do fund managers hold cash? What do they do with it?

Paul's Answer:

There are two basic reasons to hold cash in a fund: administrative and investment.

Obviously, shareholders can redeem their shares any time, and a fund must be able to pay for those shares in cash. And in most funds, new investments arrive in the form of cash. Thus cash is constantly coming in and going out. Most funds experience periods when cash flow is much heavier in one direction than the other. After a particularly favorable short-term performance, a fund often receives what seems like a flood of new cash. On the other hand, a poor quarter or a poor year will sometimes trigger a wave of redemptions.

Some funds, by the way, have established lines of credit so they can borrow money to meet heavy redemptions without selling off holdings from the portfolio. Obviously, that only works when the heavy redemption traffic is temporary.

In addition, any fund has regular expenses for operations, and some cash is needed to cover them. All these are administrative needs.

More interesting are the investment reasons a fund might hold cash. At one extreme, index funds rarely hold much cash, because their job is to remain fully invested in whatever asset classes they are tracking. At the other extreme, I am co-portfolio manager of the five Merriman Mutual Funds, which may hold as much as 100 percent cash when our timing systems indicate extraordinarily high risks. As I write this, our funds' cash positions range from 65 percent to 40 percent. Our funds' current cash positions are posted on our Web site, www.MerrimanFunds.com.

Many actively managed funds' cash positions reflect the mood of their managers in some way. Some managers hold cash because they believe stocks are overpriced - and consequently are inferior as new investments to cash, which at least earns interest and won't decline in value (except for inflation).

Collectively, the percentage of mutual fund portfolios held in cash is sometimes cited as a measure of the sentiment of fund managers. Changes in overall cash holdings may indicate trends or expected trends.

Finally, some analysts believe that when funds are relatively flush with cash, that cash provides a ready store of "buying power" that's available to pump up the demand - and with it the prices - of stocks. Conversely, when funds' cash positions are very low, these analysts may believe this dampens the likelihood of short-term stock price rallies.