Commentary July 8, 2010, 2:00PM EST

Investing: When Cash Takes a Vacation

Hedge funds, investors, and corporations are all sitting on piles of money. Here's how to make markets attractive again

By Roben Farzad

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For those who lost big in the crash of 2008-2009, there was one thing more galling than having to open those bright red brokerage statements: knowing that the smart money was profiting from your pain. It was hard enough to watch your home lose value; discovering that hedge fund manager John Paulson earned $15 billion for his investors from betting on the housing bust didn't make things any easier. So it might be comforting to realize that right now the smart money is every bit as confused as the rest of us.

Hedge funds are scaling back their trading as money managers absorb the impact of a 2.8 percent second-quarter decline—the worst second-quarter performance since 2000—and struggle to make sense of where global economies and markets are headed. Credit Suisse Group's (CS) prime brokerage unit estimates that its hedge fund clients increased their excess cash to 24 percent of their assets in June, compared with 19 percent three months earlier.

It isn't just hedgies who are frozen in the headlights. American households are sitting on nearly $8 trillion in cash—money that's earning virtually no return because people are so wary of additional losses. U.S. corporations are hoarding at a record pace as well. According to Moody's Investors Service (MCO), cash at U.S. nonfinancial corporations stood at $1.84 trillion in the first quarter of this year—a 27 percent increase from early 2007. As a percentage of total company assets, cash is at its highest level in half a century.

"There's a degree of not knowing what sectors or securities to emphasize," says Tim Ghriskey, chief investment officer of Solaris Asset Management, a Bedford Hills (N.Y.) firm with $2 billion under management. "There's also a high degree of correlation among stocks, so it's not the best environment for stockpicking or sector allocation. Investors are not moving money."

Max Trautman, a former Goldman Sachs (GS) proprietary trader who co-founded London-based Stoneworks Asset Management in 2006, is now paring his $460 million fund's market exposure. "We're trying to reduce risk by downsizing our trades," he says. "It's not that we have stopped taking views, but we're just putting less risk in them."

As Trautman and other hedge fund managers try to figure out the ramifications of such events as the European sovereign debt crisis, new U.S. financial regulations, and China's attempts to cool an overheated economy, they've been reluctant to put their money to work—even though having less money in the market makes it harder for managers who lost money to rebound from losses in May.

Still, some hedge fund investors want their managers to avoid large bets this year. Their caution will have been vindicated if the present market correction morphs into anything resembling the carnage of 2008—giving them a great new buying opportunity. "It's all about capital preservation at the moment," says Amit Shabi, a Paris-based partner at Bernheim Dreyfus, which farms out client money to hedge funds. "The losses of 2008 are still fresh in investors' memories, and so managers should be cautious." Hedge funds lost an average 19 percent in 2008, the industry's worst returns since Hedge Fund Research began tracking data in 1990.

COLLISION COURSE

When does holding so much cash go from being a virtue to a vice? When it conspires to undermine the attractiveness of the capital markets. Corporations that are offering neither a handsome dividend nor any real prospect for growth can scarcely expect to attract investors. And hedge funds with high cash positions and low returns are eroding their own high-priced reason for being. While individual investors are free to squirrel away legal tender—they have historically shown a knack for diving back into the market after a runup—their institutional and C-suite counterparts have no such luxury. Professionals are not being overpaid to run glorified certificates of deposit. By definition, businesses must earn a return above their cost of capital, while fund managers must keep watch over their own performance. "Shareholders demand a return no matter what the economic environment," says Sean Kraus, who manages $2 billion in client assets as chief investment officer of CitizensTrust in Pasadena, Calif. "If you don't put cash to work, they will simply sell." And if you lose their money, as so many funds did in 2008, they will sell faster—hence the newfound preference for cash.