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I know there are many different answers for this depending on the strategy of the fund.

I have heard that some funds invest cash from incoming fund purchases into money markets until they are ready to buy new shares.

Would a fund typically purchase all shares in various investments at the same time, or would they implement a type of dollar cost averaging, i.e. moving money into investments gradually, like a mutual fund investor would?

I'm not looking for answers about how a fund picks the individual investments, but more around how they execute on those decisions.

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As you alluded to in your question, there is not one answer that will be true for all mutual funds. In fact, I would argue the question is not specific to mutual funds but can be applied to almost anyone who must make an investment decision: a mutual fund manager, hedge fund manager, or an individual investor.

Even though money going into a company 401(k) retirement savings plan is typically automatically allocated to different funds as we have specified, this is generally not the case for other investment accounts. For example, I also have a Roth IRA in which I have some money from each paycheck direct deposited and it's up to me to decide whether to leave that money in cash or to invest it somewhere else. Every time you invest more money into a mutual fund, the fund manager has the same decision to make.

There are two commonly used mutual fund figures that relate to your question: turnover rate, and cash reserves.

Turnover rate measures the percent of a fund's portfolio that changes every year. For example, a turnover rate of 100% indicates that a fund replaces every asset it held at the beginning of the year with something else at the end of the year – funds with turnover rates greater than 100% average a holding period for a given asset of less than one year, and funds with turnover rates less than 100% average a holding period for a given asset of more than one year.

Cash reserves simply measure the amount of money funds choose to keep as cash instead of investing in other assets.

Another important distinction to make is between actively managed funds and passively managed funds. Passively managed funds are often referred to as "index funds" and have as their goal only to match the returns of a given index or some other benchmark. Actively managed funds on the other hand try to beat the market by exploiting so-called market inefficiencies; e.g. buying undervalued assets, selling overvalued assets, "timing" the market, etc.

To answer your question for a specific fund, I would encourage you to look at the fund's prospectus.

I take as one example of a passively managed fund the Vanguard 500 Index Fund (VFINX), a mutual fund that was created to track the S&P 500. In its prospectus, the fund states that, "to track its target index as closely as possible, the Fund attempts to remain fully invested in stocks". Furthermore, the prospectus states that "the fund's daily cash balance may be invested in one or more Vanguard CMT Funds, which are very low-cost money market funds." Therefore, we would expect both this fund's turnover rate and cash reserves to be extremely low. When we look at its portfolio composition, we see this is true – it is currently at a 4.8% turnover rate and holds 0.0% in short term reserves. Therefore, we can assume this fund is regularly purchasing shares (similar to a dollar cost averaging strategy) instead of holding on to cash and purchasing shares together at a specific time.

For actively managed funds, the picture will tend to look a little different. For example, if we look at the Magellan Fund's portfolio composition, we can see it has a turnover rate of 42%, and holds around .95% in cash/short term reserves. In this case, we can safely guess that trading activity may not be as regular as a passively managed fund, as an active manager attempts to time the market. You may find mutual funds that have much higher cash reserves – perhaps 10% or even more.

Granted, it is impossible to know the exact trading strategy of a mutual fund, and for good reason – if we knew for example, that a fund purchases shares every day at 2:30PM in order to realign with the S&P 500, then sellers of S&P components could up the prices at that time to exploit the mutual fund's trade strategy. Large traders are constantly trying to find ways to conceal their actual trading activity in order to avoid these exact problems.

Finally, I feel obligated to note that it is important to keep in mind that trade frequency is linked to transactions costs – in general, the more frequently an investment manager (whether it be you or a mutual fund manager) executes trades, the more that manager will lose in transactions costs.

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    Thank you. This sounds like what I had been expecting it to be. Very thorough! – Matt Phillips Oct 6 '11 at 14:04
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Most funds keep a certain amount in cash at all times to satisfy outflows. Net inflows will simply be added to the cash balance while net outflows subtract. When the cash gets too low for the manager's comfort level (depends on the typical pattern of net inflows and outflows, as well as anticipated flows based on recent performance), the manager will sell some of his least favorite holdings, and when the cash gets too high he will buy some new holdings or add to his favorite existing holdings. A passive fund works similarly, except the buys/sells are structured to minimize tracking error.

  • yes but do they literally hold it in cash or is it MM funds? – Matt Phillips Oct 7 '11 at 17:31
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    It mostly has to literally be cash because it has to be available within one day to investors redeeming their shares and even money market instruments may take 2 days to settle. – Tal Fishman Oct 7 '11 at 17:35

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