Canadian equity fund managers may not need to be reminded, but it doesn’t hurt to tell them that market-timing doesn’t work.

There’s a lot to be read from cash positions. Data from the Investment Funds Institute of Canada show that average asset-weighted monthend cash levels in Canadian equity mutual funds have crept up steadily in the first nine months of 2006. Cash positions in Canadian equity, Canadian equity (pure) and Canadian focus equity categories rose to an average of 6.8% as of Sept. 30, up from 4.6% as of Jan. 31. Data from Globefund confirms the same trend.

“That is a significant jump,” says Eric Kirzner, a professor of finance at the Rotman School of Management at the University Toronto who teaches a course in portfolio management. “Think about what that means for a $300-million or $400-million portfolio. It is significant number.”

It’s impossible to generalize about what is happening under the hoods of mutual funds by taking a snapshot of cash positions, says Dan Hallett, president of Dan Hallett & Associates Inc. , an investment consulting and independent mutual fund research firm based in Windsor, Ont. It’s been a volatile year, he notes, and the fluctuating valuations of the Canadian market could affect cash positions.

“Funds can be sitting on excess cash for many reasons,” he says. “Too much money, market-timing, high inflows, high outflows, volatile fund flows and not enough attractive securities to buy. Some managers tend to sit on more cash than others to be able to pounce on opportunities. Others are adamant about staying as fully invested as possible.”

But there is reason to consider a possible relationship between cash and market-timing these days. One can understand why investors might not want to wade into these markets. By the third quarter, the energy and materials sectors were weighing in at more than 40% of the S&P/TSX composite index. There was a sense that a drop was inevitable.

In September, the price of oil had its single greatest percentage drop in one month in at least 40 years. The index heaved on that scary ride, finishing the third quarter relatively flat. This was accompanied by speculation about how the U.S. housing bubble could keep the American consumer from buying cars, boats and guns.

Predicting the volatility of this fall’s markets, an assistant professor at the University of Missouri-Columbia in Columbia, Mo., published a paper on cash positions and stock-picking ability in the Summer 2006 issue of Financial Management. In his study, Xuemin Yan had sought to find out if better stock-pickers hold less cash. It stood to reason that, because the primary cost of holding cash is lost investment opportunity, better performers generally hold less of it.

Yan notes that cash tends to be a drag on long-term fund performance; between 1926 and 2002, stocks outperformed cash by about 7.5% a year in the U.S.

The study, entitled Determinants and Implications of Mutual Fund Cash Holdings, compared risk-adjusted returns between 1992 and 2001 for 2,069 domestic U.S. equity mutual funds against their average cash positions, which he arranged in quintiles from 0.19% cash all the way to 14.45%.

He found there was no relationship at all.

The study showed there is “no evidence that cash holdings are related to the managers’ stock-picking ability, whether they can consistently pick the winner and losers,” says Yan, who holds a doctorate in finance from the University of Iowa.

The study also showed there was no negative correlation: higher cash holdings didn’t yield lower risk-adjusted returns. Yan notes that one wouldn’t expect a relationship between risk-adjusted returns and cash holdings. An active manager couldn’t realistically invest in 99% cash and lament his low gross returns, he notes.

“At the same time, there is a lost opportunity cost, but I am not taking that into account by analysing risk-adjusted returns,” he says.

Yan’s overall conclusion is that, on aggregate, market-timing doesn’t work — although he concedes that a small portion of the funds may sometimes successfully time the markets.

It is accepted that it is, psychologically speaking, that small, random chance that brings gamblers back to the slot machines. A random sampling at the end of September of 35 Canadian equity mutual funds reveals a range of cash holdings from -0.8% (meaning a manager is borrowing cash for some reason) to 12.7%. Two managers held positions higher than 10%, and two were borrowing.

@page_break@How much or how little cash one thinks is reasonable is probably subjective. But, Yan says, it is possible to show which are the market-timers out there. If one takes for granted that less than 2% cash is probably too little — certainly a negative cash position is — and anything above 10% is too high, then some percentage of managers in those situations are market-timers. “If that is what you believe, I have the data to show that 20%-25% of managers attempt to time the market,” he says.

Fund managers know if they are market-timing. But, Yan says, the message for investors is not to bother looking at managers with low cash holdings for good stock-pickers: “And perhaps avoid managers who have huge cash holdings, because that might distort your portfolio if they are not holding to their mandate.”

A few percentage points might not make a huge difference. But, Kirzner says, if you are trying to sort your client’s asset allocation, large cash positions can be troublesome. He adds that if you are investing with a manager who holds a lot of cash, at least be aware of it.

Winnipeg-based Larry Sarbit, as an extreme example, is up front about his large cash positions. He says he won’t invest when he is not finding good, cheap business ideas, and advisors know that when they put clients into his funds.

Sarbit says he does not “market watch” and listen to economic news for direction, maintaining it’s easier to be sanguine on the Prairies, far away from Bay Street. But there is always something out there to scare people, he adds.

“These systems are made by people. A lot of it involves psychology and groupthink. I’m guessing that an investment committee often has policy changes,” says Sarbit, whose Sarbit U.S. Equity Trust is about 60% invested. “They’ll say: ‘We’re scared of this market, and as a company we’re moving to cash.’ That happens. It’s all about what’s going on inside their heads.”

Yan’s study is a glimpse into the U.S. fund industry. He addresses all the factors that might affect cash positions, including asset type, fund size, transaction costs, investor cash flow volatility, mean fund flow and management costs.

His study finds small-cap funds, which tend to have higher transaction costs, hold more cash in case they need it; funds with more volatile fund flows hold more cash in case they need to cover redemptions; and funds inside families hold less cash because the funds can borrow from one another to meet unexpected large redemptions.

Advisors might shake their heads at these two nuggets buried in the data: fund cash inflows are directly related to past performance; and funds generally hold about 0.5% less cash at the end of the year.

Dividend payments may account for some of that, but so will what Yan calls “window dressing — using cash to purchase past winners at yearend.” IE