Inside Mutual Fund Portfolios: The role of cash holdings

Investors often notice varying levels of cash across equity mutual fund schemes. A look at why fund managers hold cash in their portfolios.

WHAT IS CASH HOLDING IN AN EQUITYORIENTED MUTUAL FUND SCHEME?

In an equity mutual fund, cash holdings refer to the portion of assets under management (AUM) held in cash, bank deposits, or highly liquid short-term instruments such as treasury bills and overnight money. This is the part of the corpus not deployed in equities or longerterm investments.

WHY DO EQUITY MUTUAL FUND SCHEMES HOLD CASH?
Fund managers may build cash when they believe markets or specific sectors are overvalued and when they struggle to find quality stocks at reasonable valuations. Instead of investing at elevated prices, they allow cash to accumulate, creating a reserve to deploy during market corrections. Since cash carries minimal volatility and earns modest returns, a fund with, say, 10% cash will typically fall less than a fully invested peer during market declines, providing a buffer for investors. Open-ended mutual funds also need to meet daily redemption requests.

To manage this, they maintain a baseline cash level, typically 1–5% of the scheme’s AUM, to avoid selling core holdings at unfavourable prices. Funds investing in less liquid segments, such as small caps, may hold higher cash buffers. In periods of stress, liquidating such stocks can lead to significant impact costs; holding cash helps mitigate this risk.

WHAT DOES A HIGH CASH HOLDING INDICATE?
A high cash level, typically above 8–10% in an equity fund, signals a deliberate tactical stance by the fund manager. While most Indian fund managers remain largely invested, those who take cash calls use them to reflect caution. A sustained build-up in cash may indicate the manager believes market valuations are stretched or not aligned with fundamentals, or that suitable investment opportunities are limited. Rather than compromising on quality, the manager chooses to wait for better entry points.

WHY DO MANY FUND MANAGERS AVOID HIGH CASH HOLDINGS?
While higher cash levels can provide downside protection, they also carry the risk of underperformance. If markets continue to rally despite the manager’s caution, the cash portion will generate significantly lower returns than equities. This can result in underperformance versus benchmark indices and fully invested peers, which in turn may trigger investor outflows.