When Cash Is Bad for Funds

The last few months of solid returns have certainly convinced many that now is a great time to invest. You certainly don't want to miss that opportunity -- but some mutual funds look like they may be missing out.

Are they chock-full of terrible stocks? No. Do their returns stink? Not necessarily. They simply have too much cash.

Mind you, it's good for a mutual fund to have some cash on hand. On any given day, some shareholders will want to withdraw part or all of their money. Ideally, these outflows are offset by other shareholders buying shares -- but sometimes, withdrawals outpace investments. During the market meltdown over the last year, panicking shareholders rushed to cash out. (That's kind of silly, because the best time to be in a market is often right after it's plunged.)

Funds also may want to have cash on hand, so that they're ready when great investing opportunities present themselves.

Unfortunately, while we're sitting smack in the middle of a great big opportunity, some mutual funds are still sitting on a lot of cash -- rather than deploying it.

Paying the price
Too much cash in your mutual fund could cost you. Keep in mind that the expenses you pay on your fund investments each year also include what it holds in cash. So if you have $10,000 in a mutual fund that charges a 1.5% expense ratio, and the fund manager has 20% of its assets sitting in cash, then you're forking over 1.5% of $2,000, or $30, for no good reason. You could keep that cash in a cookie jar and save the $30, or let it earn 1.5% interest for you somewhere and make $30.

Worse still, lots of cash, especially in this environment of beaten-down stocks, suggests that the fund managers can't decide what to do with it. If you're paying for their expertise, you'd like to see them investing most of the assets at their disposal. Here are some funds that recently held significant cash:

Source: Morningstar. As of March 31.

When you see a fund with a lot of cash, you needn't automatically rule it out. But you can it as a red flag requiring further investigation. Find out why it has so much cash. See if it's usually held a lot of cash. You can call the fund company and ask, or see what the managers have said in recent communications.

Look at recent performance, too, and the stock market's current environment. If the market has been surging for a while, your fund's managers may fear that it's overvalued. If managers have trouble finding great investments, they may be awaiting a pullback to buy better bargains with their accumulating cash. Alternatively, if the market has tanked, or the fund has just performed poorly, managers may be keeping a lot of cash on hand to distribute to shareholders who are cashing out. That's not such a good sign. Fortunately, it's not so hard to learn how to find superior funds.

Don't let these complex calculations dampen your enthusiasm for funds in general. In many ways, mutual funds remain the best investments ever.

For more on finding the right funds, read about:

• These funds could make you a millionaire.
• You should jump on this opportunity before it disappears.
• The most-overlooked investment right now.