Why cash isn't trash for great fund managers

Most mutual fund managers stay fully invested more or less all the time -- meaning they don't keep cash on the sidelines to pay back departing shareholders or take advantage of buying opportunities. When shareholders flee, fully invested managers are unable to shop. If redemptions are steep enough, they may also be forced to sell holdings to raise cash.

So, why don't more managers keep a bit of money on the sidelines? One key reason is that some investors and financial advisors say they'd prefer to have control over how much they'll devote to stocks, bonds, and cash; they don't want a cash-hoarding manager mucking around with their overall asset allocation. This argument picked up steam during the bull market of the late 1990s, when being anything but fully invested was akin to career suicide for investment managers.

I'd wholeheartedly agree that you don't want to see a manager raising cash in an attempt to guess the market's direction. But wouldn't you prefer that your manager not put cash to work if he or she couldn't find anything to buy? I know I would. If only more managers had balked at the frothy market valuations in late 1999 and early 2000. In a similar vein, I also don't mind if a manager keeps a bit of cash on hand for a rainy day.

With that in mind, I'll highlight some fine funds that aren't shy about holding a bit -- or even a lot -- of cash. Sure, holding cash can mute their returns in a big market rally, but it can also smooth out the bumps when everything is going down.

Fairholme (FAIRX) - Lead manager Bruce Berkowitz and the team keep cash on hand when they can't find enough to buy, and they'll also hold cash so that they can seize on opportunities that arose -- essentially, so they can be buyers when others were sellers. (That's similar to the philosophy that Warren Buffett uses when managing Berkshire Hathaway.)

Longleaf Partners (LLPFX), Longleaf Small Cap (LLSCX), Longleaf International (LLINX) -- The Longleaf team holds cash when it is unable to find stocks that meet their criteria at a given point in time. All of the Longleaf funds have generated fabulous returns since their inceptions and have also done a superb job of preserving shareholder capital during down markets. The International fund is the only Longleaf offering that is open to new investors, but I heartily recommend it.

FPA Crescent (FPACX) -- This moderate-allocation fund will go anywhere -- including stocks, bonds, and convertibles -- to find undervalued securities. Manager Steve Romick will also go nowhere -- meaning he'll hold cash -- if he's not finding anything compelling to buy. I like the idea of a go-anywhere fund that puts an emphasis on preserving shareholder capital.

Yacktman (YACKX) -- Would-be investors in Yacktman Fund need to be prepared for periods in which it dramatically underperforms its peer group and the S&P 500 Index. Its tendency to hold cash and maintain a concentrated portfolio leads to extreme peaks and valleys. Yet the fund's underperformance has usually been relative rather than absolute, meaning that the fund can lag its peers but rarely loses money.

Delafield (DEFIX) -- Big cash stakes result when Delafield's managers can't find names that meet its criteria, and that can damp performance in bull markets. But in my experience, investors care more about absolute rather than relative returns, and from that standpoint shareholders and would-be shareholders are apt to be just fine here no matter what the market climate.

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