July 6, 2014 4:47 p.m. ET  As stock indexes hit record highs, nervous investors increasingly face a difficult choice: Do they keep betting as heavily on the markets, or do they move more money into cash?  The answer isn't so simple.  Cutting exposure with the aim of putting cash back to work when valuations drop can be soothing at first, but maddening if stocks continue climbing. What's more, many nonprofessionals don't have the expertise to accurately gauge valuations.  And there is a fine line between adjusting exposure based on valuations and timing the market, which few individual or professional investors have done successfully.  Eric Cinnamond of Aston/River Road Independent Value is among a small group of mutual-fund managers who are comfortable letting cash pile up in their portfolios.  He believes small stocks are "outrageously expensive" and have significant risk. But his fund's huge amount of cash—around 70% of assets recently—is earning almost nothing, hurting performance as markets move higher.  For investors who are considering such a strategy, here are a few things to keep in mind.  With interest rates so low and stocks climbing, holding a lot of cash in a portfolio recently has been costly. But value managers view it differently: Cash not only can buffer a portfolio against market corrections, it provides flexibility to buy again after prices have fallen a lot.  You won't know the actual value of cash until after a complete market cycle, when you can see how you fared reinvesting it, says Charles de Vaulx, chief investment officer at International Value Advisers LLC in New York. "The true return on my cash incorporates the fact that it will enable me to make tons of money later, on a depressed stock or bond," he says.  IVA Worldwide, a diversified global fund that Mr. de Vaulx helps manage, returned an average 11.2% a year over the five years through June, a little behind its average peer but with less volatility, according to Morningstar Inc. MORN +0.32% Morningstar Inc. U.S.: Nasdaq $68.54 +0.22 +0.32% July 11, 2014 2:12 pm Volume (Delayed 15m) : 17,235 P/E Ratio 26.09 Market Cap $3.06 Billion Dividend Yield 0.99% Rev. per Employee $199,563 07/11/14 Five Popular—but Dangerous—Inv... 07/08/14 Alcoa Swings to Profit; Projec... 07/06/14 Alpine International Real Esta... More quote details and news » MORN in Your Value Your Change Short position  So far, cash hasn't been a winner for Aston/River Road Independent Value, which was launched in 2011: The fund has a three-year average annual return of 5.7%, trailing the average small-value fund by almost nine percentage points, according to Morningstar.  But Mr. Cinnamond's strategy has paid off big in the past. At the fund he previously managed, Intrepid Small Cap, varying cash levels contributed to the fund being a top performer during the market downturn of 2008, as well as in 2009, when he snapped up shares near the market's bottom. (Both IVA Worldwide and Mr. Cinnamond's Aston/River Road fund are closed to new investors.)  Professional investors don't decide whether stocks are cheap just based on the level of a broad index like the S&P 500. They screen hundreds of individual stocks daily, looking to buy companies trading at large discounts to the manager's calculation of underlying value, based on a series of measures. They use similar screening to decide when to sell.  For people who aren't trained to do such analyses, "the risk is that they build up their cash and don't know when to get more invested," says Greg Estes, who manages Intrepid Disciplined Value.  Rather than raising and lowering stock exposure without a thorough analysis, investors might simply use a basic rebalancing strategy to ensure they are buying when prices tumble and selling when they rise sharply, says John Rafal, founder and principal at the Connecticut-based advisory firm Essex Financial Services.  For instance, an investor with moderate risk tolerance would typically allocate 60% of his or her portfolio to stocks. The investor might review and tweak the portfolio four times a year, buying or selling some stocks to keep the equity allocation in line with that target. The process brings discipline to investing, requiring that an investor take profits after rallies and rebuild equity positions after valuations have fallen, Mr. Rafal says.  Instead of trying to mimic professionals, individuals can adopt a value-focused strategy by buying funds whose managers trim stockholdings when shares look pricey and hold cash until valuations decline. But they will need to scrutinize a fund's portfolio—and perhaps call the fund's information line—to find out whether the manager ever lets cash accumulate beyond a modest level.  Only about 3% of nearly 7,500 U.S. equity funds tracked by S&P Capital IQ recently had cash positions of 10% or higher. Typically, funds keep just 2% to 3% in cash, primarily for redemptions, says Todd Rosenbluth, director of ETF and mutual-fund research at S&P Capital IQ. Some funds are prevented by prospectus from keeping more cash, and many fund firms probably assume that their shareholders will have a separate cash holding elsewhere, he says.  One fund that is open and gets a top rating from S&P Capital IQ is mid-cap-focused Putnam Equity Spectrum, which recently held about 15% in cash. Another is Primecap Odyssey Growth, which invests in small-, mid- and large-cap companies. It recently had about 7% in cash.  Morningstar, meanwhile, gives high marks to Weitz Value and Weitz Partners Value, two large-blend funds that each recently held about 30% in cash. Morningstar also gives favorable ratings to Longleaf Partners, a large-blend fund with 27% in cash, and foreign-large-cap-focused Tweedy, Browne Global Value, with 20% in cash. All are open to new investors.  Funds that sometimes hold large cash positions don't always move in sync with peers or benchmark indexes. Approaching market tops, they may become increasingly cautious, while peers remain fully invested. Thus, it is common for such funds to trail peers when stocks are roaring higher like last year.  Over time, however, such funds often deliver strong returns with less risk, says S&P Capital IQ's Mr. Rosenbluth. "On a risk-adjusted basis, these funds will hold their own," he says.  He cites Invesco Charter, a large-cap fund that recently had about 12% cash. It ranked in the top half of its Morningstar grouping in 2011, when stock volatility was high, but slipped to the bottom 20% last year, when stocks rallied. Nevertheless, the fund's 10-year annual average total return of 8.1% beat the S&P 500 and its average large-blend peer—and came with less volatility and a significantly better risk-adjusted rating, or Sharpe ratio, than for its category on average.  Southeastern Asset Management Inc.'s Longleaf Partners Small-Cap is an example where a deep-value strategy and patience likely helped long-term performance, according to a Morningstar analysis. An average annual return of 10.6% over the past 15 years puts the fund in the top 10% of Morningstar's midcap blend grouping for that span, even though the fund lagged behind peers in 2007-09 and again last year, when it held more than a third of its portfolio in cash. The fund, which is closed to new investors, also scores better than peers in measures of volatility and risk-adjusted return, or Sharpe ratio.  The managers declined to comment. However, in a paper describing their approach, they said building cash isn't a top-down call on valuations, but rather a result of investing in companies with "honorable, capable management" and shares priced at a deep discount to intrinsic worth.  A similar deep-value conviction at FPA Capital, however, has produced what Morningstar analyst Dan Culloton calls "mixed results." While an average annual return of 10.5% over 15 years puts it in the top fifth of its midcap grouping, the fund has slipped to near the bottom of its category for the past three-year period, with slightly higher relative volatility and a lower Sharpe ratio.  Dennis Bryan, an FPA Capital manager, says that the fund must keep more cash on hand than peers because it is closed to new investors and that it often underperforms when stocks are booming. He says the fund's relative short-term returns may not be great by some metrics, but performance has been strong when returns are adjusted for the sizable cash holding, or converted to a measure called "return on invested capital."  Mr. Pollock is a writer in Ridgewood, N.J. Email him at reports@wsj.com.
Cutting market exposure has hurt returns lately, but proponents say playing it safe eventually will pay off. One option for individual investors is to pick a mutual fund whose manager is willing to let cash accumulate when stocks are expensive.