Mutual Funds Madness – Staying Fully Invested in Bear Markets?

The majority of Mutual Funds have to be fully invested in the markets at all times regardless of the volatility or state of the market. I wondered why this is so because it flies in the face of reason.

An interesting article written in June 2004 by Maria Brill called The Cash Conundrum explains why this is so.

In 2003 the recent bull market began and there was a massive inflow of money into mutual funds. Some funds who acted rationally and in their investors interest like First Eagle U.S. Value Fund. They found they had more money to invest than good investment opportunities. Charles de Vaulx a co-manager of the fund said,

“We will only buy securities at prices we like, and when we can’t find them, we will let cash build.”

This makes good sense to me if using their skill and expertise they felt some of my money was better in cash at that time then so be it. This meant they had 20-25% of their assets in cash. When you consider the typical fund only keeps less than 5% of its assets in cash to meet redemptions, this was considered unusual to say the least.

But many financial advisors complained about funds keeping much of the investors money in cash. Roy Diliberto of RTD Financial Advisors in Philadelphia said,

“It stinks when funds move large amounts of assets into cash. If we want cash in a portfolio, we will make that decision.”

But he did make a valid point when he asked why they didn’t reduce their management fees for money that was in cash. I agree with this statement.

One startling statement was made by Rick Ferri, an advisor with Portfolio Solutions in Troy, Mich., who agrees that funds should stay fully invested at all times. “We won’t buy funds where the manager has the ability to move into cash,” he says. “That decision should be left to us.”

Is your financial advisor of the same mind-set? It’s like putting a straight-jacket on a fund manager because it takes away his ability to manage your investment if financial planners don’t recommend his fund because he may not be fully invested all the time.

A second concern is why should the financial planner make that decision if you are the investor? His job is to advice you not make decisions like that on your behalf.

It seems to me there is a good case for having a fees structure that charges a higher fee when the manager is actively investing your money as opposed to keeping it in cash and waiting for an investment opportunity.

Other financial planners said fund manager should not be pressured to be fully invested at all time. Again something with which I agree.

However since 1990 the trend has been for funds to be fully invested at all times. Many fund managers were forced by peers pressure to follow the fully invested at all times strategy even though it made no sense in all circumstances. Even many of the prospectus’ state the funds are to be fully invested at all times. Add some marketing hype to put fear into investors about losing out if they were not fully invested and everyone is a true believer.

Maybe with the massive inflows of capital that occurred in 2003-2007 underpinned the market and created another market myth to always buy the dips. It was a self-fulfilling event because money kept pouring in to buy those dips.

We should have learned our lesson after the 2000 Dot-Com bubble and subsequent crash though. Then all sides did a re-think and many believed that having 20% or so of your assets in cash was not a bad thing if there was nothing of value to buy.

“The recent change in thinking came after the manager of an aggressive small-cap mutual fund his firm owned shifted some money to cash in 1999 and 2000 because valuations were too high, a move that helped cushion the sharp bear market decline. “I consider that to be implementing valuation principles, not market timing,” says Roe.”

Note the “not market timing” phrase mentioned above. Cash is a position.

Alas history was soon forgotten once the 2003 bull took off and nobody wanted to miss out, neither fund manager or investor. Funds again became fully invested and many have just lost 20-30% of their value which may means 20-30% of your retirement nest egg.

I suspect many have taken profits wherever they can, which helped to send the market down further than it might have gone. They are now sitting in cash up to their allowed limits within their prospectus’. Just check with your funds what their cash positions are and you will know if they took profits (or worse sold at a loss) to get into cash ready for the next bottom picking buying frenzy.

Get your bank shares here two banks for the price of one – going cheap! ;0(

You need to remember funds in most cases only need to beat an index. If that index is down 20% and the fund comes in with only a 19% loss (that means they have lost 20% of your money), they have beaten the index of benchmark by 1%. Break out the champagne as its bonus time again.

However I do want to say I understand and accept fund managers will not always get it right so losses will occur from time to time. What I object to is when they stay fully invested so as not to offend their peers and don’t even try to protect our nest egg investments. Then tell us to wait 5-7 years to recover the losses or what’s worse say we cannot draw out pension and have to return to the work force.

In the Australian Financial Review on the weekend there is a great article by Chris Wright that is worth reading no matter what country you live in. It is called “Did Your Fund Beat the Trend?”. The top performing domestic Australian fund, SGH Absolute Return Trust is up 12% in this market. Yes you read that right – up 12%. The second best fund had a return of -2.7% – over 14% worse. SGH did this by:

  • picking the stocks they liked
  • Didn’t have to hold large stocks
  • Limited the number of stocks to 20-25
  • Going Long or Short in the markets
  • Being able to be up to 50% in cash
  • Not having to beat an industry benchmark

The best performing International fund was RCM Global Equity Unconstrained Fund which returns a positive 0.3%. Not much but it avoided large losses which it rule #1 and has its capital intact, ready to invest when the time is right. Again as its name implies it is “unconstrained” so the manager can effectively manage the fund. Right now over a third of the assets are in cash.

After reading the article by Maria Brill I am seeing fund managers in a new light, at least the ones that have broken away from the “be invested at all times” pack. I think we all need to ask our Financial Planners to find “unconstrained” fund managers and research their performance and consider investing with them for the long term.

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