Cash levels in some UK large-cap funds reached as high as 30% in the past three years, Morningstar data can reveal, and these funds have underperformed cheaper trackers that hold virtually zero cash.
We looked at the 142 funds in the Morningstar Large-Cap Equity category and the level of cash they have held each month over the past three years, to determine their average cash allocation over that period.
Within the group, four have had an average cash level of more than 10% over the past three years: JOHCM UK Opportunities Fund, JPM UK Equity Plus Fund, Schroder MM Growth and Jupiter UK Special Situations.
At the other end of the spectrum, the fund with the lowest average cash level, the Vanguard FTSE 100 Index has an average of 0.04% of its assets allocated to cash.
"Cash can be a headwind to returns and it can quite frustrating for an investor seeking equity exposure to find their chosen fund has 5% or 10% held back in money market instruments," says Mark Preskett, portfolio manager at Morningstar Investment Management. He says funds that are "fully invested" (ie. those that have all of their money in equities and none in cash) often perform better.
Indeed, there appears to be some correlation between cash levels and performance – just one of the four funds noted above has beaten the Vanguard tracker on a three-year annualised basis. Over five-years, the Silver-rated Fidelity Index UK tracker fund, which has cash levels close to zero, has also beaten all of the four cash-heavy funds with an annualised return of 6.28%.
Of the 142 funds in the group, 133 have had an average of 5% of less of their assets in cash over the past three years. Of these, 83 had an average cash buffer of less than 2%, and 33 of these have had an average cash holding of less than 1% over that period.
| Fund | 3-yr Average Cash Level % | 3-yr Annualised Return % | Morningstar Analyst Rating |
| JOHCM UK Opportunities | 24.65 | 4.46 | n/a |
| JPM Uk Equity Plus | 18.36 | 9.15 | n/a |
| Schroder MM UK Growth | 12.14 | 2.28 | n/a |
| Jupiter UK Special Situations | 10.48 | 3.18 | Silver |
| Vanguard FTSE 100 Index | 0.04 | 5.75 | n/a |
| Fidelity index UK Tracker | 0.01 | 5.74 | Silver |
| Large-Cap Equity Category Average | 2.5 | 5.03 | n/a |
| Source: Morningstar Direct 31 December 2019 |
Cash Drag
The argument for having as little cash as possible in a portfolio is that investors, in choosing an equity fund, have opted to up their equity exposure to the maximum. They can choose cash, which preserves capital but currently doesn’t keep up with inflation, themselves.
But with global stock markets hitting multiple record highs in the past two years, being out of the market has been costly for investors. “If a fund manager decides to hold cash in their fund rather than allocate to equities, it will definitely have an impact on future returns,” says Preskett. “Given the compounding of gains over the long-term, holding cash for an extended period can hurt," he adds.
As an example: £10,000 invested in the Vanguard US Equity Index tracker 10 years ago would have grown to £43,994. However, investing £9,750 in the market and £250 in cash (ie. a 2.5% cash weighting) and rebalancing every year, the gain would have been £42,605.
This effect is known as cash drag - it is the extent to which the cash you hold limits your overall returns. In this case, the investor with no cash drag was £1,389 better off.
Of course, high cash levels are just one factor in the outperformance of passive versus active funds - trackers are dominated by large-caps, which have outperformed small-caps in this bull run. They also tend towards growth stocks such as tech companies, which have similarly outperformed value stocks.
The Case for Cash
One of most cash-heavy funds in the list is Jupiter Special Situations, run by Ben Whitmore, which is highly rated by Morningstar, with an Analyst Rating of Silver. Morningstar analysts praise his “genuinely contrarian and value-based approach” and note his “willingness to raise cash levels when he thinks absolute valuations are too high”. Indeed, while the fund's cash levels are currently around its target level of 4%, in August 2019 its cash allocation hit 16.5%, according to Morningstar Direct data.
But the strategy seems to have paid off over the long-term; over 10 years, the fund has returned an impressive 10% on an annualised basis. The L&G 350 Index Fund, meanwhile, has produced an annualised return of 7% over the same period,
The biggest argument for holding cash is it allows managers to sit on the sidelines if they think share prices look expensive; they then have cash ready to put to work when an opportunity presents itself.
The mandate of the JOHCM UK Opportunities fund allows it to hold up to a third of assets in cash and other liquid assets. Its managers, Michael Ulrich and Rachel Reutter disagree that managers are "hoarding" cash, but say they have a "shopping list" of high-quality businesses they want to buy and are quite often just waiting for the shares to fall to the right price before they put their money to work. "We will deploy our cash when changes in valuations, balance sheets or management behaviour turn these individual risk/reward pay-offs in our favour, but only then."
John Teahan, co-manager of the RWC Enhanced Income fund, agrees that holding cash is a strategy managers can use if they think market valuations are too high. His fund's three-year cash average is just below 10% and peaked in 2017 at 20% but is now around 4%. Back then, Teahan says the stocks on his radar were looking overvalued, so he held back some firepower. "If we feel that the market is expensive and the opportunities are few, we will allow ourselves to run cash to higher levels," he says. And the fund's yield of around 6% suggests that investors are not losing out because of this strategy.
But why don't fund managers just hold short-term ETFs rather than cash? After all, this allows the funds to stay liquid while also staying invested in the market. Teahan says a more strategic option is to use cash as well as "put options" (a type of derivative), which pay out if markets fall. He says in 2017 he used cash and derivatives, but currently prefers to run low cash and keep the put options as an insurance policy in case the market crashes.
Timing the Market
Preskett argues that with stock markets largely in a buoyant mood - despite the trade war, coronavirus and Trump's impeachment - holding above-average cash is going to be an unpopular strategy.
But for those managers who are brave enough to hold cash when the market turns, the strategy could boost their returns and establish their reputation as someone who can time the markets. Those with higher cash levels just before the Brexit vote in 2016 would have been rewarded for their caution, for examplek, as the market fell heavily and then recovered.
"It is not uncommon for managers to let cash build in times of market stress, and we saw a lot of this in the global financial crisis," says Preskett.
Ultimately, the argument goes back to the choice between active and passive funds - you are paying more than a tracker to back a manager's convictions on the market with the hope that they can beat the index. If they manage to achieve that, does it matter that they did so while holding "too much" cash?
