Fund managers don’t normally seem averse to spending other people’s money, so why are some reluctant to hold cash within their portfolios? It may be that they’re under pressure from investors who think that an actively managed fund needs to be just that – actively managed. Well, in any case, the more active you are in a given market the closer you will move towards beta. And if that’s what you’re after then a lower-cost passive fund would be more to your liking.
It’s certainly easy to appreciate why some investors would be aghast to think they’re paying for managers who sit on cash piles in anticipation of inflection points in the market. But we seriously doubt if many fund managers – so-called ‘market timers’ – actually tailor their portfolios solely in anticipation of peaks and troughs in the market. While such a strategy doesn’t automatically bring to mind images of monkeys and dart boards, it certainly wouldn’t inspire confidence; particularly if you take the view that modern equity markets are probably less efficient than they’ve ever been.
This view derives in part from the pace of technological change; some maintain that electronic trading platforms have inadvertently propagated the herd dynamic in investment markets at the expense of a rational appraisal of future prospects. A theory has also taken root which proposes that markets have become less efficient because of the predominance of nominee accounts. Though fund managers generally have greater information at their disposal, their incentives aren’t always aligned with those of the unit holders themselves. Conflicting interests are at play. It’s not an uncommon charge that big institutions will provide share price support to certain stocks because of entrenched commercial ties. Such a practice would be aided by the very scale of institutional capital flows. Critics of modern-day investment houses believe many pay little more than lip service to the concept of ‘Chinese walls’. It’s a point borne out by the manipulation of markets in credit default swaps in the aftermath of the US sub-prime property collapse – but that’s another story.
It would be ironic if an imperfect relationship between those who provide investment capital and their agents was the principal distorter of equity markets. That two major asset bubbles book-ended the opening decade of the millennium suggests that even if investors (and their agents) were fully cognisant of all relevant market information, irrationality held sway for the most part.
Taking all this on board, perhaps one could arrive at a clearer picture of where markets are headed by the level of non-commitment on the part of fund managers; in other words, the proportion of funds under management given over to cash. After all, there’s little incentive in taking a short-term position in equity markets if you believe it’s unlikely to outstrip the risk-free return on a 30-year bond. An analysis of equity and fixed income cash positions since 2005 was recently published by eVestment Research. The data shows an inverse correlation between index values and managed cash positions. The all-market median cash position of fund managers accelerated from the third quarter of 2007, before peaking during the first quarter of 2008. This correlation only became apparent in European markets in the wake of the 2008 financial crisis. Ergo, in the second quarter of 2011, the median cash position in Europe equity funds recorded its largest increase since the height of the financial crisis. In the following quarter, the MSCI Europe Index duly fell by 11.4 per cent.
Why should this interest us now? Well, cash positions in actively managed portfolios have been trending downwards from the height of Europe’s sovereign crisis right up until the end of the fourth quarter of 2013. However that trend appears to have reversed during the first quarter of this year. The eVestment analysis makes the point that “increases in cash positions across many developed markets have preceded, or occurred in tandem with equity market draw-downs.” Second quarter data is due to be published shortly, so it will be interesting to note if funds have continued to cash-up through to the end of June. According to eVestment, US fund managers “are more apt to use cash in a strategic manner”, so any further reversion to cash on their part could indicate that a market correction is imminent.
