When selecting a mutual fund there is an area that is commonly overlooked, and that is cash reserves.

Perhaps you have heard the saying, ‘Cash is king’, well that may be well and good but it’s not king when you are paying your mutual fund manager to sit hoard it. I can do just fine sitting on my own cash and I don’t think I need to pay someone two percent to sit on it for me.

With a historical return of 4% on cash why is my mutual fund manager sitting on so much of it. I am not talking about conservative income funds or the money markets; I am speaking of actively managed growth funds with ten percent of their holdings being cash. When you buy shares of mutual funds you are paying them to own stocks and you are not paying them to own cash instead.

There are basically two reasons for keeping so much cash on hand. The first reason is they are keeping the cash on hand just in case shareholders suddenly decide to sell of their shares of the fund. Should the end of the world be nigh, they have the cash there so they do not have to sell stocks when they are at the lowest prices ever.

In addition to that mutual fund managers keep some cash available is to take advantage of times when the market is oversold and there is a fire sale in the equities market. It the classic buy low sell high, timing the market. Obviously managers do this because they think they can time the market and actually get in at the low. No one else can do that but apparently fund managers can, or so they would have you believe. In theory this is great but in practice it has turned out the opposite.

Research shows that mutual fund cash reserves are at their low right when the market is at the high and at their highest levels when the market is at its lows. In other words, if there is anyone who knows how to time the market (probably not); mutual fund managers are not those guys.

Good luck and happy investing.

Most of the mutual funds go long (buy and hold) on the stocks. Some of them short the stocks. Few mutual funds practice long-short strategy meaning that they go long some stocks in their portfolio and short the rest of the stocks.

Traditionally, mutual funds used to buy or short the stocks. They don’t normally play with options. Derivatives like options are the favorite of hedge funds. Mutual funds tend to stay away from the derivatives to reduce the volatility. However, in the recent years some mutual funds were started to adapt the “buy-write” strategy which essentially is writing covered calls on the stocks owned.

What is covered call? If you own a stock, you can write a call option on that stock. You already own the stock, so it is “covered call”. If you write a call option on a stock without owning the stock, it’s called “uncovered call” or “naked call”. Ok, don’t ask me why it’s called naked!. May be because some people lost their cloths by writing uncovered calls.  Covered calls are conservative play. Uncovered calls are dangerous, there is literally no limit for the loss if uncovered call option position goes against you.

When you write a call option on a stock, you promise the buyer to deliver the stock at a certain price on or before a specified date. You get the call option premium from the option’s buyer to reward you for your commitment. The buyer wants to buy your call option, because he/she thinks that stock will go up soon. If the stock goes up after you write the covered call you will lose all the upside potential of the stock. If the stock goes down, the buyer of the call option lose the money.

In difficult times like the one we currently face, writing covered calls on the stocks you already own would be a prudent thing to do. Covered calls are also known as “buy-write”. Some mutual funds offer funds that use covered call strategy to reduce the volatility of the portfolio. Risk managed equity option income fund (EROAX) from Eaton Vance is one of them. This fund seems to weather the storm of the recent weeks compared to S&P 500. See the chart below for the comparison.

Disclosure: I do not own the mutual funds mentioned in this post.

If you like this post, check out the part-2 of this post.