MUTUAL FUND CASH PERCENTAGE AND CASH SURPLUS/DEFICIT (PREMIUM)

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APPLICABLE TIME FRAME(S):  

INTERMEDIATE TO LONG

UPDATE SCHEDULE:

Monthly for data covering the previous month

REPORTING DELAYS:

Three weeks, so the most recent update will be at least three weeks old.

EXPLANATION:

Each month, the Investment Company Institute releases information related to the mutual fund industry.  Among the nuggets of data is the amount of cash carried by mutual funds as a percentage of total assets.  This figure will rise and decline over time as mutual funds raise cash (either by selling stocks and/or by attracting new assets) or pare down their cash reserves (by buying stocks and/or losing money through expenses or redemptions) respectively.

A high level of cash on hand can be bullish for the stock market since it reflects a sizable pool of money that can be put into equities at any time.  On the other hand, a low cash level can be bearish. 

A low cash reserve is of concern for a couple of reasons, with the most common argument being that if funds begin to get a large number of redemptions from investors, and they have a minimal amount of cash on hand, then they will need to sell stock in order to meet their cash needs, fueling the market decline that is most likely the reason for the redemptions in the first place. 

There are many reasons why a fund would hold a low level of cash:

• They believe the market is going higher and want to be as fully invested as possible.

• They use derivative securities (such as futures and options) and don’t need actual cash on hand in order to hedge their portfolios.

• Their charter (or a mandate from investors or management) requires that they remain as invested as possible, having enough cash on hand only to meet expected redemptions.  They are not expected to time the market, only find good stocks.  With the improved reporting systems now in place at some fund firms, portfolio managers can see redemptions on a virtual real-time basis, reducing the likelihood they will wake up one day with a cash crunch.

• The increased influence of index funds precludes market timing.  These managers aren’t expected to give investors a positive absolute return, they are only expected to beat their respective benchmark index.

• There aren’t many other instruments available that would give their investors an acceptable reward for the risk they are taking. 

It is on that last point that we need to focus.  On the site, we show both the percentage of assets in cash, and also a unique chart showing cash levels adjusted for the prevailing level of interest rates.  When short-term interest rates are high, mutual funds have something of an incentive to hold cash.

The logic is sound - if you are a fund manager, and there is a risk-free investment that will pay you a 10% return, are you going to put your money there or are you going to risk it in the stock market where you may get an 8% return during a good year, but with a heckuva lot more heartburn? Most of us would surely switch to the risk-free opportunity.  For our purposes, we use the yield on 90-day Treasury Bills as the risk-free rate.

This logic is supported by the numbers. The correlation between mutual fund cash levels and the 90-day T-Bill rate is 0.74, which means that the prevailing level of interest rates can theoretically explain 55% of why mutual fund cash levels are where they are. So with short-term T-Bills now yielding less than 1%, what incentive is there for mutual funds to hold a lot of cash (other than the bullet points mentioned above)?

Using statistical modeling, we can estimate how much cash mutual funds should have on hand given a certain level of interest rates.  By getting such an estimate, we can then see whether the current cash percentage is too high or too low, without the distorting effects of interest rates. 

This should give us a better feel for the underlying sentiment of the fund managers and (theoretically) provide us with an improved market forecasting tool.  In actuality, this turns out to be the case – doing this extra work improves the forecasting ability of mutual fund cash levels by a large degree.

Using this modeling technique, we can conclude that if interest rates were at 0%, then funds would normally hold 4.55% of their assets in cash.  This is a normal level of cash that funds presumably need on hand in order to meet redemptions or what have you. 

This data has been quite effective in the past when cash levels became either too high or too low, after adjusting for interest rates.  The table below shows the performance in the S&P 500 one year after the funds were in a cash surplus or a cash deficit from 1954 - 2004.  “Surplus” is defined as funds holding 2% or more cash than they should, given the level of short-term interest rates.  “Deficit” is defined as funds holding -2% or less cash than they should.

We can see from this table that one year after a surplus, the S&P was higher 85% of the time, with a whopping average return of 13%.  In stark contrast, one year after a cash deficit, the S&P was higher only 31% of the time, and suffered an average decline of 4%. 

Both of these results differ significantly from a random one-year period, suggesting that consulting this data can improve our chances of success in timing long-term investment decisions (or at least it would have in the past).

Since the market and the fund industry are both dynamic, there is no guarantee that historical relationships will continue.  However, in the past, monitoring these cash levels would have improved our chances of successfully forecasting future market direction to a good degree, so it should continue to be watched.

GUIDELINES:

Generally, we want to be positive on the market when cash levels are high (i.e. there is a "cash surplus" of 2% or more) and negative when the percentage of assets in cash is low (i.e. there is a "cash deficit" of -2% or more). 

This is a very long-term indicator, best used when one's outlook is at least one year in the future.  Due to the delayed nature of the data, and its inherent qualities, it is not intended as a specific timing mechanism, and should not be used as such.  Rather, it is most applicable for deciding when one should increase or decrease equity market exposure.

STATS:

*Standard Deviation.  See below...

68% of readings (1 standard deviation) should be between -1.5% and 1.5%

95% of readings (2 standard deviations) should be between -3.0% and 3.0%

99% of readings (3 standard deviations) should be between -4.5% and 4.5%

In other words, we should expect a reading under -3.0% or over 3.0% approximately 13 times per year.  Since such a reading would be relatively unusual, it suggests that we may be seeing an unsustainable trend.  These figures assume a normal distribution curve.

ADDITIONAL RESOURCES:

Investment Company Institute (www.icinet.net)

© 2005  Sundial Capital Research, Inc.  All Rights Reserved.