Below is the article from Norm Alster.
JITTERY investors see danger in every market thrust upward. For them, soaring stocks aren’t confirmation that the future looks bright. Sustained market gains seem more like evidence that optimism has been hijacked by delusion and greed, and due in time to be exposed and reversed.
With the Standard & Poor’s 500-stock index up almost 18 percent over the first nine months this year, the skeptical and fainthearted can choose from a bulging bag of protective hedges. They can short stocks individually or the market as a whole. Some inverse index funds and exchange-traded funds are leveraged to triple any move, providing outsize profits in a market slide, but enormous risks should the market keep marching higher.
Still, for most fund managers, there is a time-tested, less risky way to protect against overexposure to an overextended market. By holding cash instead of stocks in part of their portfolios, they can cushion any fall and save ammunition to buy again when stocks are cheaper.
Many fund managers have quietly been raising their cash positions. In their latest reporting periods, according to Morningstar, the average equity mutual fund held 9.7 percent in cash, up from 8.8 percent in the previous three-month period.
Some managers are sitting on much more cash than that. John Deysher, manager of the Pinnacle Value fund, has 44 percent of his portfolio in cash. But for managers like him, not being fully invested has a price. Though Pinnacle Value is up for the year, it has lagged behind the S.& P. 500. Mr. Deysher is unfazed.
For one thing, Pinnacle Value has outperformed the S.& P. 500 over the last decade. And Mr. Deysher would sooner lag behind the market than bend the buying discipline of the fund.
“Our job is to seek out fundamentally undervalued stocks, and if we can’t find any, we’ll let the cash build,” he said. “It’s been difficult for deep value investors like us,” he added. “There’s just not a lot of merchandise.”
For Mr. Deysher, capital preservation is paramount. “We’d really like to put the cash to work but not at the risk of potential capital loss,” he explained.
But Bruce Berkowitz, who manages several Fairholme funds, goes much further in outlining the merits of stockpiling cash.
“I believe holding above-average amounts of cash leads to above-average performance,” Mr. Berkowitz said. His Fairholme Allocation fund, which now holds 14.8 percent in cash, has outperformed, soaring almost 34 percent in the first nine months this year.
Having cash on hand can be the difference between getting in on the best buying opportunities, or missing out, Mr. Berkowitz reasons.
These opportunities typically arise when markets have sold off and many managers must sell to meet redemptions from fund shareholders. “Having that cash allows a portfolio manager to buy when most do not have the cash to make investments,” he said. It also allows a fund manager to meet redemptions without having to sell stocks that still have “huge performance potential.”
“Cash can be extremely valuable — especially when no one else has it,” Mr. Berkowitz said. “Cheap purchase prices are usually created when most funds are being forced to sell.”
A case in point: “All the companies I’ve invested in in the past three years were dramatically affected by the real estate bubble,” he said. Recoveries in the shares of the American International Group and Sears Holdings have produced big gains for the Fairholme funds.
But some question the value of trying to time market moves. “Evidence suggests that market timing is incredibly hard,” said Michael Abata, a manager of the Invesco Low Volatility Equity Yield fund. “If you can do it, it’s potentially powerful — but incredibly hard to do.”
Mr. Abata does not try. The Invesco fund now has less than 2 percent of its assets in cash. With investors buying and selling shares of a fund, that is close to being fully invested. The fund managed an advance of nearly 17 percent in the first three quarters of the year.
Though he does not hedge with cash, Mr. Abata is adjusting his strategy to the realities of a market that is becoming “increasingly expensive.” He is shifting portfolio weightings toward stocks that tend to have less volatility. He recently bought shares of AT&T and Verizon. He has reduced his position in First Solar, which tends to be a more volatile stock. What would Mr. Abata do if investors started bailing out of the fund during a sharp market correction? “If we were being redeemed, we’d sell off the less attractive holdings — those that don’t have as high an expected return,” he said.
Some mutual funds require fund managers to stay fully invested. Sometimes, large investors in a specific fund stipulate that the fund avoid holding cash, said Will Browne, a manager of the Tweedy, Browne Global Value fund. “There are certainly institutional accounts that give you money and say, ‘I want you to be fully invested.’ ”
But Mr. Browne, whose fund holds nearly 17 percent cash, said he “pushes hard” against such demands. He said he preferred to buy companies at prices that are lower than what an informed buyer would pay in an acquisition. If he cannot find them, he said, he is prepared to “lag behind” market returns for a while.
One fund manager who is still finding stocks to his taste is Richard S. Nackenson, of the Neuberger Berman Multi-Cap Opportunities fund. Mr. Nackenson has been nearly fully invested, retaining slightly more than 2 percent of assets in cash.
“We’re not required to be fully invested,” he explained. “We are choosing to be fully invested in this market because we’re finding high-conviction ideas. Many of these are companies that are showing growth in current and future cash flow.”
Such cash flow growth is appealing, as it can finance investor-friendly initiatives like dividend increases and share buybacks. Mr. Nackenson said he liked the free-cash-flow growth potential of Boeing, a long-term holding to which his fund has added shares recently.
Bargains seem to be in the beholder’s eyes. Unlike Mr. Nackenson, Kimball Brooker Jr. doesn’t see many now. The FirstEagle Overseas fund, of which he is a co-manager, has a hefty 23.1 percent of assets in cash. “We’re lagging the indices,” Mr. Brooker acknowledged, emphasizing that his first goal is “not to lose money.” “We’re just being very patient,” he said.
He sees most global markets as fully valued, a somewhat uncommon situation. “It’s unusual to have synchronous full valuation around the world,” he said.
Has Mr. Brooker heard complaints from disappointed investors? “Not yet,” he replied. “For the moment, 2008 and 2009 are still in the psyches of many investors,” he said. “There’s some appeal to a strategy that will protect them on the downside.”
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