Credit is in cash

Cash is critical in an equity fund’s portfolio. A large cash component protects it from a sharp downfall. But there is also an opportunity cost of holding cash.

R. Swaminathan        Print Edition: May 29, 2008

R. Swaminathan
R. Swaminathan
That mutual fund investments are exposed to market risks and are expected to match the returns from their benchmark indices is something all aware investors understand. This brings asset allocation into play; indicating how much the fund is diversified across stocks, sectors and cash. With Sebi regulations capping the exposure to individual stocks and sectors, a fund’s cash holding is something that is purely in the hands of the fund manager. Cash allocation is tricky as it is to meet redemptions as well as for spotting new investment opportunities.

Having large cash protects the fund from a sharp downfall. But it also implies that investors miss out on sudden upward spurts. In recent times, we have experienced an increasing appetite for cash among equity funds, especially in March 2008. The question is, does holding more cash than normal reflects inefficient fund management? To find an answer I analysed equity funds over a three-year period, a fairly long term of investment.

Of the 88 diversified equity funds observed, as on 21 April this year, 28 funds (30%) outperformed the Nifty. The schemes that could not beat the benchmark on that particular date aren’t necessarily bad. Their performance will depend on the market movement and use of cash. On 31 March this year, a dozen diversified equity funds had over 20% cash exposure, with Sundaram BNP Paribas Capex (29.99%) and LIC Mutual Fund Growth (29.47%) topping the list. These may be stray aberrations and do not prove conclusively the benefit or the lack of it in the efficiency of equity funds that hold more cash.

Cash is a critical component of equity mutual funds’ portfolios, but there is an opportunity cost of holding cash. Funds that maximise shareholder wealth should set the fund’s cash holdings at a level that the marginal benefit of cash holdings equals the marginal cost. A good allocation to cash can see the fund manager utilise funds optimally and tide over both the market’s ups and downs.

R. Swaminathan is Vice-President, IDBI Capital Market Services

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