There's been a lot written lately about the relatively high cash levels that mutual funds are holding.

These cash levels are watched closely because conventional wisdom says that high cash levels mean ample buying power on the sidelines - buying power that will eventually come into the market and push stock prices higher.

While such thinking is not without merit, it is important to understand how these cash levels are determined. Most market watchers look at a mutual fund's cash level as a percent of assets in the fund.

Let's say a mutual fund has $500 million in total assets. Of that $500 million, the fund has $50 million in cash and $450 million invested in stocks. That would mean the fund is holding 10% of its assets in cash (50 divided by 500).

The problem with viewing cash as a percentage of fund assets is that it can lead to some dangerous comparisons, especially during weak market periods.

Let's continue with our previous example. This fund's total assets are $500 million, with $50 million in cash. Now, let's say the stock market gets whacked around, and stock prices fall sharply. In this case, the fund loses 20% of its total value. That means total assets fall from $500 million to $400 million. But the fund still has $50 million in cash. After the market decline, the fund now has nearly 13% of its fund assets in cash (50 divided by 400).

The fund has raised money, right? No, it hasn't. The fund actually has the same amount of cash ($50 million). It's just that the value of the stocks in the fund has declined, thus making cash a larger component of the total fund.

What I'm trying to say is that when market commentators say a fund's "cash levels" have risen, actual cash levels may not have risen at all.

Bottom line: Don't accept certain things at face value. When someone says cash levels are rising, make sure they mean actual cash levels and not cash as a percentage of total fund assets.

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