Who's to say stocks are expensive: You or your fund manager?

By Stan Choe
AP Business Writer

NEW YORK (AP) — Being cautious can sometimes be the boldest move of all.

Consider Josh Strauss, a self-professed bargain hunter and portfolio manager at the Appleseed mutual fund, which owns a mix of stocks and bonds. He gets interested in a stock when confidence in it has plunged, and his goal is to buy when its price is 50 percent lower than what he thinks it should be.

When Strauss looks at the stock market today, he finds pickings so slim that he would rather invest in nothing in many cases. Roughly 16 percent of the Appleseed fund is sitting in cash. Another 15 percent is invested in gold because he’d rather bide his time in safer investments than buy into a stock market that he considers too expensive.

“We want to deploy capital when prices are attractive, and they’re just not,” Strauss says. “Every time there’s a sell-off, the market comes right back.”

Strauss is part of a relatively small group of mutual-fund managers willing to stash large amounts of their portfolios in cash, even as stock prices approach record highs. Roughly three dozen of the more than 2,000 funds categorized as U.S. stock funds have a quarter or more of their holdings in cash, according to Morningstar. These managers see a market that looks expensive by several measures and say they’ll protect themselves, and their shareholders, by sheltering in cash.

“Welcome to the most expensive U.S. stock market in history,” Brian Frank, a portfolio manager, wrote in his quarterly letter to shareholders at the end of March. His Frank Value fund has 64 percent of its portfolio in cash. The fund has historically kept an average of just 5 percent in cash, going back to its 2004 inception.

“Our computers look at 3,000 companies a day. I did in-depth research on hundreds last year and I bought just one: Barrick Gold,” Frank says. “That’s how few and far between it is to find good valuations out there.”

Most fund managers agree that the stock market looks either fairly priced or expensive, but certainly not cheap. Several measures of the market’s value, such as the price of the Standard & Poor’s 500 index versus how much profit and revenue companies are producing, are above their averages from the last few decades. Much of Wall Street is forecasting gains for stocks over the next year, but only modest ones.

Still, the vast majority of fund managers aren’t hiding out in cash, even those who see the market as expensive. And it’s often because that’s what they think shareholders want.

Every mutual fund keeps some cash on hand. They need it to return to any investors who sell their fund shares that day, but it’s usually just a small piece. The average U.S. stock fund has less than 4 percent of its portfolio in cash.

One reason many stock funds stay “fully invested” is because their shareholders may be taking it upon themselves to decide when to dial back on stocks and increase their own cash holdings. So they may be looking at the fund as part of the “stock” portion of their portfolio, separate from the cash that they may be already holding in a money-market fund or bank.

Such investors don’t need a stock fund manager to hold cash for them, and they’d rather not pay the higher expenses that stock funds charge above money-market funds. That’s particularly the case when the yield on money-market funds is a shade above nothing. Other investors don’t want to try to time the market and prefer leaving their stock and cash allocations alone.

That’s why it’s important to check in on your fund and see if the managers take it upon themselves to back out of stocks when they consider prices too high, or if they leave the decision up to shareholders. Invest accordingly.

Some types of funds are more clearly in one camp than the other. Index funds will generally remain fully invested. “Allocation” funds, meanwhile, regularly shift their investments from one market to another depending on where they see the best value.

A fund that hides out in cash when it senses trouble has clear upsides: Not only does it offer protection if stocks are about to fall, it also preserves a cache of what the industry calls “dry powder.” If stocks crash, these funds will have cash on hand to buy low when the market is cheap. Funds that remain fully invested, meanwhile, will fall with the market and have less ability to buy.

Investors need to have faith in the judgment of these managers. If the market continues to rise, those large cash holdings will hinder their performance. Not only that, being in a fund where the managers were too early to go to cash can be just as painful as being in one where the managers were wrong about stocks being overpriced.

This has been a long-doubted bull market for stocks, and many investors who fled to cash in earlier years missed out on the gains made in the interim.