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With these tremendous influxes of cash, however, the typical investment manager faces some obstacles, one of which is how to quickly and efficiently deploy the millions of dollars sent in each day from investors. At various times, certain funds have taken in new cash at a rate of $25-$50 million per day! If that cash is not invested quickly and the market continues onward and upward, the fund will suffer from cash drag-i.e., the underperformance of a portfolio due to holding too much cash in a rising market. (Of course, holding cash in a bear market is a good thing, but we haven't had much downside action in the past 18 years.) Even small amounts of uninvested cash can shave hundreds of basis points off a portfolio's returns. This problem is magnified in index funds, as cash must be invested in the underlying index as quickly as possible or tracking error develops. If an index fund manager has $25 million in investible funds, he must get all $25 million invested before the close of business. Otherwise, if his index opens up sharply the next day, he will be sitting on a mound of cash that will underperform its benchmark. To be sure, fund managers want to carry some cash to meet the requests of investors looking to redeem shares. Otherwise, the fund would have to sell shares in various holdings to raise cash, which can create three significant problems: 1) It can disturb a portfolio that took a lot of time and talent to assemble; 2) It creates a taxable event; and 3) It entails commissions, slippage and, of course, turnover-the three mortal enemies of market beating performance.
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Mutual fund assets have risen sharply in the last 15 years. In 1990, for instance, the Va n g u a rd 500 Index Fund, which tracks the S&P 500 Index, had just over $2.1 billion in assets. Recently, according to Morningstar, the fund had grown to over $106 billion in assets! And while the Va n g u a rd 500 is an extreme example, it is by no means unique: According to the Investment Company Institute (ICI), mutual fund assets rose from less than $1 trillion in 1990 to more than $8 trillion by the end of 2004. Part of this growth is due to good investment returns over the years and part is due to substantial inflows of cash from investors wishing to profit from the enormous wealth created by the U.S. economy.
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