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Funds hoard cash over fear of redemptions - and win by mistake

The outperformance of actively managed equity funds amid the crumbling markets of the fourth quarter could well boil down to a single word, and one of the simplest in the investing dictionary at that.


When I wrote a column a couple of days ago about the strong performance of actively managed Canadian funds relative to the S&P/TSX composite index in the quarter, I expected to hear outrage from active fund managers about the column's conclusions that over the longer term, most active management fails to justify the high costs it incurs for investors. Instead, I was inundated by e-mails from investors and investing professionals arguing that even in the short-term instances (such as the past quarter) when active management does appear to earn its money, it may have little - or nothing - to do with the stock-picking acumen of their celebrated and highly compensated fund managers.

"In the case of severe market declines like 2008, anyone can 'beat the market' by simply putting a significant portion of a portfolio into cash. My strong suspicion is that the active managers that 'outperformed' in 2008 did so because of unusually high cash holdings," said John De Goey, financial planner and vice-president at Burgeonvest Securities Ltd., a long-time critic of the high costs and fees involved in actively managed funds. "That's not stock picking; it's the antithesis of stock picking."

What's worse, there's a suspicion that much of this move to cash was more out of necessity than design.

As the market eroded in the second half of last year, sales of equity mutual funds began to dry up and redemptions accelerated, reflecting investors' desire to steer clear of falling equities. This forced fund managers to liquidate holdings and increase their cash balances, in order to ensure they had cash on hand to cover investors' demands to take their money out of the funds. And the worse things got, the more fund managers kept cash on the sidelines, lest a run of redemptions force them into a fire sale of assets to cover the cash demand.

The result, the active-management skeptics say, is that by keeping cash on the sidelines, a portion of the active managers' funds were spared the brunt of the deep selloff of October and November. The butt-covering turned out to be a butt-saving.

Certainly, some of the available mutual fund data and anecdotal evidence lend support to that argument. Merrill Lynch's monthly survey of global fund managers shows that funds around the world moved to record overweight cash levels in the fall. And the Investment Funds Institute of Canada's monthly sales and redemption numbers show that net redemptions of equity funds surged over the fourth quarter.

However, it's worth noting that gross redemptions for Canada's equity funds, while somewhat elevated last year, weren't way out of the range of normal by historical standards. That suggests that, contrary to common belief, fund managers weren't actually getting inundated by investor demands to get their cash out in the fourth quarter, and as a result really didn't need that much more cash on hand than they would have normally. They may have been selling more stocks than usual to cover these redemption needs - since they weren't receiving much in the way of fresh cash from new investors buying into their funds - but the actual amount of cash they maintained in their portfolios wouldn't have needed to be much different than usual.

So, if Canada's active equity fund managers were, in fact, significantly expanding the cash weighting in their portfolios, they were doing so more as a conscious investing strategy than as a means to fund redemptions. If that allowed them to save their funds from the deeper losses that the broader market incurred - as it appears to have done - then it was a worthy strategy.

Okay, maybe that's not as impressive as shrewd stock-picking. But still, if you invested with an active manager who chose to sit on the sidelines, whether by necessity or by strategy, you benefited.

Then again, you would have benefited the same way if you'd just held onto your own cash rather than placed it in the scary equity market. And your costs would have been a lot cheaper.

© 2007 The Globe and Mail. All rights reserved.

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