Should An Equity Mutual Fund Scheme Hold High Cash Balances?
Jun 19, 2019

Author: Divya Grover

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Equity mutual fund is an ideal investment avenue for people who want to invest in stocks, but with a lower cost and smarter diversification. The main objective of equity funds is to facilitate capital appreciation over long-term, though the strategy to achieve it may differ from fund to fund.

As per the SEBI mandate, equity funds must invest at least 65% of their total assets in equity and equity related instruments.

Some funds undertake higher risk to achieve higher level of capital appreciation and hence they prefer to have a higher exposure to small-cap and mid-cap companies. On the other hand, some funds look to offer stability to the portfolio along with capital appreciation and so they invest in less riskier stocks like large-caps and multi-caps.

The investment strategy or the style that a fund manager follows differs depending on the manager's perception of the market condition. The investment strategy could be top-down, bottom-up, growth or value.

Having the right level of cash holding in the portfolio is as important as selecting the right stocks and investment strategy. Equity funds hold a small percentage of their assets in cash and cash equivalents. Cash holdings are generally in the range of 5-10% of the portfolio and can be lower for some schemes. However, some schemes hold high cash balances, in many cases more than 20% of the portfolio.

Should equity mutual funds hold high cash balances?

As equity investors are expected to stay invested for the long term, the redemption is assumed to be lower as compared to debt funds where the investment horizon is short-term. Thus, the requirement for cash to meet redemption demand in equity funds will also be lower.

So why do some equity funds hold high cash balances?

Cash balances are held to meet redemption demand and to seize any stock buying opportunities that the fund may come across.

Equity funds may hold high cash balances if the markets are overvalued. The fund managers anticipate that the market will correct itself sooner or later and the prices will come down to reflect its actual value. This will give them an opportunity to buy good stocks at lower prices.

[Read:  Sensex Near 40,000! Do You Have A Robust Investment Strategy In Place?]

Newly launched funds also have high cash balances to accumulate good stocks and build their portfolio.

When the markets fall, funds with low cash holdings will see a fall in their returns too, while those with high cash balances will perform better.

On the other hand, if the markets are undervalued and if the fund anticipates growth opportunities, they will prefer to have low cash balances and look to invest in stocks. Index funds have low cash balance as they follow indices and do not look for buying opportunities.

Cash balance should be high only as long as the fund anticipates buying opportunities in the near term. Holding cash balances for prolonged period should be avoided. This is because the investors are required to pay expenses to the fund to manage stocks and earn higher returns.

When cash holdings are high, the fund's transactions will be low and hence expenses involved in managing the fund are lower. At such times, charging higher expenses to investors would be unfair.

The level of cash holding impacts the fund's performance and also shows the fund manager's ability to perceive market conditions. Market conditions and future expectations are crucial for the manager to understand the level of cash to be held.

Table: Mutual Fund schemes with high cash holdings

Scheme Name Equity (Cr) Cash (Cr) Cash holding (% of total assets)
Principal Small Cap Fund-Reg(G) 48.25 67.56 58.33
IDBI Dividend Yield Fund-Reg(G) 63.45 48.73 43.43
IDBI Healthcare Fund-Reg(G) 22.87 10.93 32.33
Quant Small Cap Fund(G) 1.61 0.54 25.11
IDBI Focused 30 Equity Fund-Reg(G) 207.90 50.75 19.62
IDBI Long Term Value Fund-Reg(G) 133.41 29.50 18.10
Tata Small Cap Fund-Reg(G) 284.54 57.44 16.79
ICICI Pru Bharat Consumption Fund(G) 529.32 102.02 16.15
Kotak India EQ Contra Fund(G) 727.57 125.12 14.67
ICICI Pru Manufacture in India Fund(G) 1030.94 164.99 13.79
(Data as on May 2019)
(Source: ACE MF)

Most of the funds in the above table that have high cash balances such as Principal Small Cap Fund, IDBI Dividend Yield fund and IDBI Healthcare Fund have been recently launched. Thus the high cash holdings will be used to seize buying opportunities and design their portfolio.

In terms of category wise cash holdings, small cap funds and sectoral/thematic funds have highest number of schemes holding high cash balance.

Should you look at cash holdings before investing?

Since the market is currently overvalued, you may feel that it would be right to invest in funds with cash holdings. However, selecting a fund this way is detrimental to your financial health because it involves timing the market.

Funds should be selected after evaluating the quantitative parameters like historical performance and performance relative to benchmark and peers as well as qualitative parameters such as quality of the portfolio and the efficiency of fund manager/house.

[Read:  How To Check If A Mutual Fund Scheme Is A Consistent Performer Or Not]

Additionally, determine if the fund aligns with your goals, risk appetite, and time horizon. Invest regularly through systematic investment plan (SIP) to avoid timing the market and mitigate risk.

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