The power and risk of holding cash Don't let that lone loonie under the car seat fool you. When enough of them get together they can become a powerful investment force. Cash - the often overlooked asset class behind equities and fixed income - has a life of its own for money managers trying to get an edge in volatile markets. "The level of cash a manager holds reflects what sort of strategy they have," says Christopher Davis, director of fund analysis for Morningstar Research. He says managers with a bullish view of the market tend to deploy their entire store of cash while bears will accumulate cash to cushion a potential blow from a market downturn. If they're wrong, their investors could pay the price. If a fund has a high cash level and the market does well, the fund's performance isn't going to be as strong. If the cash level is relatively high in a down market the fund is probably going to perform better than the overall market," he says. According to Morningstar Research, the median Canadian equity fund has a cash weighting of about 3 per cent of total assets, which is consistent with the 10-year average. However, cash levels tend to fluctuate with market conditions, often peaking at the bottom of a market such as early 2003 and early 2009. High cash positions in down markets often reflect a mutual fund manager's defensive strategy but one contributing factor, according to Mr. Davis, is the need to have cash for redemptions from investors looking to get out of a fund. It's one reason active managers have had a hard time keeping up with the benchmarks, especially in up markets because any level of cash is a drag on performance. He points to the Beutel Goodman Income fund as an example of a strategic cash position. Of the fund's $2.2-billion in assets, 28.5 per cent is cash. Like any bond fund it is vulnerable to rising interest rates because newer bond issues with higher yields devalue existing bonds, which have lower yields. "In a rising rate environment fixed income is going to perform worse than cash," he says. At the opposite end of the spectrum many equity funds are fully invested and have no significant cash. He says equity or balanced-fund managers have defensive options other than cash that can also generate income such as dividend stocks. The exception to the equity rule could be value-fund managers who often need to keep cash handy for further purchases. "If they can't find stocks cheap enough they will just hold cash until opportunities come along," he says. Cash in mutual funds can also be controversial. Mutual funds charge unit holders fees based on total assets invested and that could mean paying a manager 2 to 3 per cent just to hold cash. If the manager were to hold a large percentage of the portfolio in cash over a long period of time, then I would say you're not getting what you're paying for. But if the cash reflects where the manager is finding opportunity you may be getting what you're paying for," Mr. Davis says. Not all money managers agree. "I would prefer they not have a lot of cash and I would rather manage that cash decision on my own," says Andrew Pyle, senior wealth adviser at ScotiaMcLeod. He feels cash levels are a personal matter for individual investors. I can decide if I want to have more cash. I'll simply take little pots out of the equity and fixed-income funds. Mr. Pyle deals with cash on a client-by-client basis setting definitive targets through a formal investment policy statement. The target is generally 5 to 10 per cent of a portfolio but could go higher if a client is planning a major purchase such as a cottage. "Each person is going to have a unique need for high liquidity access to cash for all sorts of purposes," he says. Many portfolio managers, including Mr. Pyle, include money-market funds in their definition of cash. Money-market funds hold short-term debt - normally less than one year - and can be liquidated within hours. They also charge annual fees as high as 1 per cent of the total amount invested. Factoring in the fee in the current low interest rate environment, the average Canadian money-market fund has returned only 0.3 per cent over the past year. "You're not going to earn anything in cash ... you're going to get a better yield in short-term fixed income," he says. His advice to nervous investors who want the security of cash without sacrificing returns is short- to medium-term bonds or short-term bond funds. I've never seen much sense in having lots of volatility in your cash position for defensive reasons. I'd rather say let's just have more fixed income if you really think the world is going to fall apart tomorrow. One other risk to holding cash is inflation. Inflation is tame but Mr. Pyle cautions cash-rich investors that a higher cost of living down the road could actually diminish their savings. If I own a bond that's earning 3 per cent and inflation goes to 3 per cent, I'm net zero. If I'm making zero, I would have a negative 3-per-cent return on my money.