Wouldn’t it be amazing if someone gave you 1% returns for free? Now, imagine if you had to give away 1% for no reason. That would be painful, right? Most of us hate paying fees, and all of us prefer to save on costs wherever we can. But this is exactly what we end up paying for when mutual funds hold high cash balances.

Mutual fund expense ratios exist because there are costs associated with managing the fund—transaction costs, salaries of researchers and portfolio managers, etc.; while the extent of this is debatable, it still makes sense. What doesn’t make sense is when these mutual funds hold high cash balances, we are effectively paying them for doing nothing, i.e. giving them free money.

We all have limited capital to invest, and when we allocate that money in equity mutual funds, we pay the manager to employ her expertise to generate returns. However, if the fund manager simply holds on to cash for prolonged periods, investors still end up paying the fund manager for merely holding cash, when they could’ve taken out that money and invested it in other assets.

It’s like if your doctor admits you to a hospital but then later doesn’t provide any treatment—you stay in the hospital and pay a daily admittance fee for just being there despite not receiving any medication. For example, let’s say that your equity mutual fund’s TER (total expense ratio) is 2%, and the same fund had an average annual cash holding of 25% in 2018. This means that you paid them 0.5% for free in 2018—for an investment of 10 lakh, that’s equivalent to paying 5,000 for free. Wouldn’t you rather put that 2.5 lakh (25% of 10 lakh) in fixed deposits and earn 7% or 17,500 instead?

This is not just a hypothetical example. We analysed the monthly portfolio of all mutual funds across 2018, and found that many funds had high cash holdings, with many around the 20% mark. To make this even worse, these funds also happen to have high expense ratios. It is no surprise as such that many of these funds also performed quite poorly when compared to their respective benchmark total-return indices.

Now, there are many good reasons to hold certain amounts of cash. One common one is if the manager anticipates business uncertainty (and thus volatility) in the near future, which often happens before elections. Or if the manager thinks current valuations are too high and that the markets will fall in the near future, in which case they’ll hold cash until such time that the markets crash and buy stocks when they’ve become cheaper. For instance, the fund manager of Quant Small Cap Fund took a bold decision to hold 46.89% in cash on average, and because of that relatively outperformed the Nifty Small Cap index which bled more than -12% in the last financial year.

There is no perfect balance to how much cash a fund should hold when. But what’s certain is that a high cash balance is a practice that’s unfairly charging investors. Perhaps fund houses could reduce expense ratios for such time periods when they have high cash holdings, returning the same to investors in the form of lower TERs next month—after all, the funds would definitely be incurring lower transaction costs due to less trading activities since they are holding more cash. Or they could simply give this money back to investors. The ideal solution will require a lot more thinking and inputs from industry stakeholders, but it should be something that holds fund managers accountable for their “active" decision to hold cash via a tangible check and which ultimately benefits the retail investor.

For their part, investors can consider more efficient instruments like exchange-traded funds (ETFs), which provide similar exposure to broad indices, themes and strategies, but don’t hold cash for investors, and as such don’t charge them unnecessarily. After all, cash is indeed the undisputed king. Why then, should one give it away for free.

Anugrah Shrivastava is co-founder and head of investments, Smallcase Technologies

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