If you want to know how nervous the UK's largest investors are about the market, look to the level of cash hoarded on fund managers' balance sheets.
When markets are frothy and valuations are looking perilously stretched, many fund managers choose to hold cash, lying in wait for a market wobble or choosing to stay out of the fray to avoid the carnage.
To harness that fact, we have put together an index mapping the cash positions of managed funds over time, effectively coming up with a fund manager fear index.
"Cash is commonly seen as a safe haven in times of uncertainty, and increased weightings to cash can indicate managers anticipate heightened volatility," says Oliver Clarke-Williams, portfolio manager at FE Trustnet. "Managers also hold cash when they have sold a holding and a high cash allocation could indicate that a manager is expecting market falls and is waiting for an opportunity to buy.
"Conversely, when a fund is performing well, it could experience a spike in inflows, which could account for a high cash position. It's unusual for managers to hold cash for long especially when interest rates are low, as this can lessen returns."
From the marked correlation between market movements and the aggregate level of cash positions, this index acts as a barometer of investor sentiment and a potential indicator of the level of risk appetite within a given market. But, like any other metric, looking at cash positions in isolation is pointless; you should aim to provide context through reference to supporting data and other market signals.
Context is important because there are a number of rather prosaic reasons why a fund portfolio might contain a relatively high proportion of cash. It could simply reflect a spike in inflows if a fund is performing well, or if there has been a change in fund manager or a change in investment strategy.
Different types of managed fund use cash in different ways, too. Equity income funds tend to be more fully invested and do not hold cash in the same way as multi-asset funds or bond funds, for example, which tend to hold more.
The JPM Income Opportunity (LU0323456540), for example, managed by Bill Eigen, has held as much as 80 per cent of his fund in cash during periods of high volatility and held 28.6 per cent of his assets in cash at the end of March 2017.
Managers may also take different views on cash strategies within the same sector. Bill McQuaker, multi-asset portfolio manager at Fidelity International, says: "There are two schools of thought in terms of holding cash for multi-asset managers. One is that markets appear fully valued and that returns are likely to be lower going forward." In this view, holding cash makes sense to reduce portfolio risk if the market corrects.
"While the opportunity cost of using cash is lower if you believe markets are fully valued, the counter argument is that holding cash is costly over the long term," he adds. "The rate on cash is currently below the inflation rate in the UK, so by holding cash you're simply eroding value. In addition, central banks are engaged in policies that impact on asset prices, both directly and indirectly, and these serve to protect high asset market valuations."
There are also certain funds mandated to invest in particularly illiquid sectors, most notably those targeting real estate markets. The turnaround between buying and selling assets in these sectors is, by definition, a drawn-out affair; buying or selling property can take months. Real estate fund managers typically need to build up hefty cash positions to fund new investments and to meet ongoing capital redemptions.
Obviously the rigidity of a fund's investment mandate will have a bearing on its cash balance. Often there are strict rules governing the amount of cash fund managers can hold, with hybrid funds required to hold a minimum percentage invested in equity and the remainder in debt or cash. This ability - or readiness - to alter the portfolio balance across asset classes can be instructive, as the differing debt/cash position should reflect the perceived value on offer in equity markets - that's the theory at any rate.
There are those that question why fund managers aren't constantly minimising the cash component of their portfolios; ostensibly, they're paid to invest in companies on their clients' behalf. Even some industry insiders believe that fund managers have a duty to invest all of their assets under management and are putting their clients' interests at long-term risk by building up cash levels. The counter argument runs that a cash component affords a fund manager a degree of flexibility, providing a means to exploit market fluctuations and perceived price anomalies.
At base level, a cash position can provide an absolute guaranteed return, minus the destructive effects of inflation - but there's obviously more to it than that. Fund managers can effectively reduce a portfolio's volatility relative to the market (or sub-sector) by boosting its proportion of cash or cash equivalents (cash-equivalent assets include government bonds with less than one year to maturity, certificates of deposit and other assets that can be turned into cash in rapid order with no loss in value). A cash-heavy fund can be expected to underperform in rising markets and outperform during falling markets.
The managed cash position, or liquidity ratio - cash or cash-equivalent financial assets, divided by the total value of managed holdings - provides a useful indicator of the investment choices made by a fund management team. A high liquidity ratio could indicate that managers believe the assets they normally invest in are overvalued and are waiting for stock prices to come down. Funds tend to have elevated liquidity ratios after markets have performed strongly and fund managers liquidate positions to lock in profits.
Although a high liquidity ratio could indicate that a given market is essentially overheated, it could also point to a coming rise in equity or bond prices. Logic dictates that if a large number of funds have accumulated hefty cash positions, then that money will have to be invested somewhere sooner or later. Returns on cash and cash-equivalent assets are often derisory, so fund managers who hold high cash positions for too long are potentially imperilling their annual returns. Under those circumstances, they must feel compelled to put the capital to work.
For our purposes, we've decided to utilise a liquidity ratio based on a range of UK funds with some of the largest pooled assets under management. As a consequence, our list includes a number of equity income funds, which has the effect of narrowing the liquidity ratio as these types of funds tend to have a higher proportion of their managed assets invested at any one time (we know that the one area that has attracted significant investment in the past year has been absolute return funds). However, the nominal ratio is subordinate to the trend - that's what really matters.
The chart covering the shorter term, from June 2014 through the present, was compiled from a larger sample group, which is interesting given that it shows a narrower liquidity range. But both charts suggest that fund managers have increased their exposure as the UK benchmark strengthened from the early part of 2013. That's not surprising, but what's worth noting is that the consequent increase in trading multiples for most of the FTSE 350 constituents over the period is not justified by a commensurate rise in underlying earnings.
