When Too Much Cash Is Bad

Hey, we all could use a little more cash in our pocket. What you don't want, though, is more cash in your stock fund. Determining how much is too much, though, can be tricky business.

Certainly, there are sound reasons for keeping cash in a stock fund. Indeed, the average U.S. stock fund has 5.1% in cash, although anything less than 10% is within the realm of "normal."

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A cash reserve gives fund managers a cushion that can ease the purchase of a new stock or additional shares of an existing holding.

Cash can also ease the sting of high redemptions, which can spell trouble for funds, especially if it means managers are forced to sell holdings they believe in. "That can be a sensible strategy," says Christine Benz, editor of Morningstar FundInvestor.

But too much cash in a stock fund means that portfolio managers need to take bigger risks with the invested portion in order to garner returns equal to (or better than) their benchmark index. That's why the driving philosophy of some fund families, such as Rydex Funds or Turner Investment Partners, is to stay 99% invested at all times -- even the universe average of 5% cash poses hazards.

"We don't want to have to take that extra risk on how we would have to invest a customer's $95 to get them the return they expect on a $100 investment," says William Flaig, senior portfolio manager at Rydex.

Then again, such strict policies can be somewhat limiting. A cash cushion, after all, is particularly helpful in funds that hold several illiquid shares -- as is the case with small- or micro-cap funds and some foreign funds. Companies with small market capitalizations -- as well as some foreign stocks -- don't trade as frequently, which means that divesting a large holding could drive the share price down. If there's cash on hand, a fund manager could avoid painful sales.

In order to keep to its policy of full investment, Rydex offers only stock funds with large-and mid-cap holdings, which are easier to get in and out of. ...