Why Cash Isn't Trash for Great Fund Managers

In the course of writing that article, however, I began to muse that part of the problem was that most managers stay fully invested more or less all the time--meaning they don't keep cash on the sidelines to help pay back departing shareholders, take advantage of buying opportunities, or both. When shareholders flee, fully invested managers are not only unable to go shopping--if redemptions are steep enough, they may also be forced to sell holdings to raise cash.

So, why don't more managers keep a little bit of money on the sidelines? One of the key reasons is that some investors and financial advisors say they'd prefer to have control over how much they'll devote to stocks, bonds, and cash; they don't want a cash-hoarding manager mucking around with their overall asset allocations. That argument really picked up steam during the bull market of the late 1990s, when being anything but fully invested was akin to career suicide for investment managers.

I'd wholeheartedly agree that you don't want to see a manager raising cash in an attempt to guess the market's direction. But wouldn't you prefer that your manager not put cash to work if he or she couldn't find anything to buy? I know I would. If only more managers had balked at the frothy market valuations in late 1999 and early 2000! In a similar vein, I also don't mind if a manager keeps a bit of cash on hand for a rainy day, as is the habit at Fairholme Fund (NASDAQ: - ).

With that in mind, I'll highlight some fine funds that aren't shy about holding a bit--or even a lot--of cash. Sure, holding cash can mute their returns in a big market rally, but it can also smooth out the bumps when everything is going down. Note: This isn't a comprehensive list--Third Avenue and Jean-Marie Eveillard's First Eagle funds are also notable, successful cash-holders about whom we've written much over the years.

Fairholme Fund
Although this fund's managers have long held cash as a residual of their investment process--that is, they wouldn't invest all of their assets if they couldn't find anything to buy--lead manager Bruce Berkowitz announced a slight shift in that philosophy in 2006. Berkowitz noted that he and the Fairholme team would also keep cash in reserve so that they could seize on opportunities that arose--essentially, so they could be buyers when others were sellers. (That's similar to the philosophy that Warren Buffett uses when managing Berkshire Hathaway (brk.b.B).) If the Fairholme team thinks that its companies' managers are good deployers of capital--and that's one of their criteria--they also take a positive view when their companies have cash on hand. The fund's cash stake--often upward of 20% of assets--damped returns during 2003's big rally, but we think that the fund offers shareholders and prospective investors a very strong trade-off overall.

Longleaf Partners (NASDAQ: - ), Longleaf Partners Small-Cap (NASDAQ: - ), Longleaf Partners International (NASDAQ: - )
In contrast to the Fairholme managers, the Longleaf team hasn't made a conscious effort to raise cash; rather, holding cash is an outgrowth of their inability to find stocks that meet their criteria at a given point in time. The merits of management's approach are reflected in the fact that all of the Longleaf funds have generated fabulous returns since their inceptions and have also done a superb job of preserving shareholder capital during down markets. Moreover, as Gregg Wolper recently reported in his analyses of the Small-Cap and International funds, management has been able to use periods of market uncertainty to deploy their cash holdings, thereby picking up securities at advantageous prices. The International fund is the only Longleaf offering that is open to new investors, but we heartily recommend it. (The fund's lackluster five-year record doesn't do it justice; since its inception, it has scorched both the foreign large-value average and the MSCI EAFE Index.)

FPA Crescent (NASDAQ: - )
This moderate-allocation fund, which reopened to new investors earlier this month, will go anywhere--including stocks, bonds, and convertibles--to find undervalued securities. Manager Steve Romick will also go nowhere--meaning that he'll hold cash--if he's not finding anything compelling to buy. The fund's sizable stake in small- and mid-cap stocks could hold it back if large caps enjoy a sustained resurgence, but we're attracted to the idea of a go-anywhere fund that puts an emphasis on preserving shareholder capital.

Yacktman (NASDAQ: - )
Would-be investors in Yacktman Fund need to be prepared for periods in which it dramatically underperforms its peer group and the S&P 500 Index. Like the aforementioned funds, management employs an exacting valuation discipline and would rather let cash build--often higher than 25% of assets--than invest willy-nilly. A concentrated portfolio also leads to extreme peaks (as it has exhibited recently) and valleys (as was the case in 1998 and 1999). Yet we'd point out that the fund's underperformance has usually been relative rather than absolute, meaning that the fund can lag its peers but rarely loses money.

Delafield (NASDAQ: - )
Delafield's management employs a valuation-conscious approach that often leads it to smaller stocks. Big cash stakes result when it can't find names that meet its criteria; cash accounted for 20% of assets as of the end of September. Like the FPA fund, this offering could struggle if the market exhibits an ongoing predilection for larger-cap stocks. But in my experience, investors care more about absolute rather than relative returns, and from that standpoint shareholders and would-be shareholders are apt to be just fine here no matter what the market climate. An added bonus: The fund has remained fairly nimble despite overall strength in small- and mid-value stocks.

American Funds
You often hear investors and advisors say, "American Funds don't blow people up" as an explanation for the firm's prodigious asset-gathering ability over the past five-plus years. The firm's experienced management team and research-intensive process have been well documented as key factors behind its funds' strong risk/reward profiles, but an unheralded reason may be their willingness to hold cash. Fully 20 of American's 24 domestic- and international stock funds held cash stakes of greater than 10% of assets as of their most recently available portfolios, and cash has averaged in that ballpark over the past three years as well. Interestingly, cash doesn't only appear in value-minded funds like American Funds Investment Company of America (NASDAQ: - ), but also in growth-oriented offerings such as American Funds Growth Fund of America (NASDAQ: - ) and American Funds Amcap (NASDAQ: - ). Like some of the aforementioned skippers, American's managers like to keep their powder dry should opportunities arise, and we don't think that it is a coincidence that American's funds have universally pleasing risk/reward profiles.

Christine Benz does not own shares in any of the securities mentioned above.