Thursday, April 12, 2012

Do cash holdings impact funds' performance?

Co-Author: Dhruva Raj Chatterji, Senior research analyst at Morningstar India

The article was first published in the Economic Times, April 12th, 2012


The debate whether cash calls of actively managed funds have worked in their favour or not has been on for a long time. We tried to delve deeper and check if equity funds in India observe better performance when holding higher cash during market downturns; or do they end up missing out on sudden upturns in the market.


In India, fund houses like Escorts, Reliance, Sahara and Taurus are known to take cash calls, 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.

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 Fidelity, Franklin Templeton, HDFC and Tata have maintained lower cash holdings, in the range of 4-8%, over the past five-year period, across most of their funds.

Taking two categories of equity funds -large-cap and small- & mid-cap -we compared the highest cash holding funds with the lowest cash holding funds. In the case of large-cap funds, the numbers reveal that the top 20 high cash holding funds held 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 (annualised) than them over the same period.

The performance is particularly poor over the 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 - although much starker. It seems that the top 10 funds with the highest cash holding within this category earned about 5.5% less (annualised) than the bottom 10 funds with lower cash holding over a five-year period. Over three- and one-year periods, they earned approximately 9% (annualised) and 6% lesser, respectively.

Cash also seems to have a varying impact, depending on the category of funds. Large-cap funds, by virtue of investing in more large and liquid stocks, are able to buy and sell the shares quickly, and hence the role of cash becomes less important.

On the other hand, in the case of small- or mid-cap funds, keeping excess cash might mean losing out on an upswing, as the lower liquidity of these shares would result in the prices zooming up due to any 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.

We observe that the key risk in taking cash calls lies in deploying it at the right time. Fund managers often miss out on a sudden upturn.

Clearly higher cash holdings have resulted in lower fund returns in the following months, especially when the markets have turned around very suddenly. 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 do point towards a more disciplined approach in investing. Moreover, the approach helps to neutralise the risk of being caught on the wrong foot, especially in the event of a sudden upswing in the market.

As legendary 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."

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