Mutual fund managers have always had to deal with the fundamental conflict between long-term investment strategies and daily liquidity requirements due to shareholder flow. Only now the problem is even more urgent.
Industry-wide net outflows, once rare, have become commonplace, as shareholders have reacted to declining or volatile markets by withdrawing their assets in droves.
In fact, long-term funds as a group experienced net outflows for the year 2008 — the first time this has happened in two decades. Fixed-income funds, international funds, and emerging markets were all hard-hit by redemptions.
Redemptions have only compounded the effects of market declines on
mutual fund AUM. More than a trillion dollars in long-term asset value
evaporated in 2008, even while the number of funds grew.
[EXHIBIT 1 & 2]
When Portfolio Managers Are No Longer in Charge
Funds facing net outflows often find themselves squeezed for cash to meet redemptions. Their choices are limited:
- Tap outside sources of liquidity, which have become less available and more costly as lines of credit have dried up.
- Liquidate securities, in essence letting shareholder flow dictate investment decisions.
- Hoard cash in advance of redemptions, an approach that distorts portfolio strategies, raises tracking error, and further lowers the amount of assets funds can invest in their strategies.
The worst repercussions occur when funds are forced to liquidate securities
to meet redemptions. This is especially true in light of worsening volatility.
Funds now are more likely to be driven into the market on days of severe
decline or disruption.
[EXHIBIT 3]
Regardless of market conditions, funds making investor-driven trades incur transaction costs that drive up expenses and diminish returns for all shareholders. Market impact and other indirect costs are only heightened when markets are adverse. As an added insult, flow-induced transactions will leave many shareholders with hefty capital gains tax bills for 2008 on top of major investment losses.
Most damaging of all, when portfolio managers must sell securities they would otherwise prefer to keep, they give up some control of investment strategies. Forced liquidations disrupt the investment process by distracting managers, diverting assets from long-term strategies, and hindering the pursuit of new investment opportunities.
Just a Temporary Thing?
In normal times, fund managers might have thought they could be sanguine about the impacts of shareholder flows, if they thought about it at all. But the current climate has dramatized what has been true all along: flow-driven trading is a performance drain mutual funds can ill afford. Moreover, it is a perennial problem that is fundamental to the mutual fund business.
The fund manager’s number-one job is to create value for shareholders
through long-term investment strategies. At the same time,
fund managers must deal with daily requirements relating to
liquidity and asset flows. Because of this built-in conflict, mutual funds have always been
continuously buffeted by the ebb and flow of shareholder assets.
[EXHIBIT 4]
It is true that until the present crisis, shareholder flows were generally steady and relatively small compared to total assets. But that argument can be turned around: Redemptions are constantly chipping away at mutual fund assets and performance. Moreover, their cumulative impacts are significant — especially in light of the narrowing performance differentials that determine fund rankings.
Research by Prof. Roger Edelen of the UC Davis Graduate School of Management found that 30 percent of all mutual funds trades were flow-induced, and that while discretionary trades increased portfolio value by 22 cents for each dollar of transaction cost, flow-induced trades lowered it by 53 cents per dollar. While these specific results may not fully represent today’s environment, they are certainly indicative of the destructive dynamics of flow.
Fund managers have much to gain by controlling the impacts of flow. A 1% improvement in performance is often enough to elevate a fund to the next highest decile ranking. According to 2008 Morningstar® data, the median gap between 5-year total return decile rankings was less than 100 basis points in 29 of 40 categories examined.
Net new flow data shows that incremental performance differences also
correlate with funds’ ability to attract new assets. Even small gains can have a
significant impact on market perception and asset flows.
[EXHIBIT 5]
Like a low-grade fever that steadily weakens the patient, shareholder flows are an ongoing, corrosive factor in fund performance. Although mutual funds may recover from their current bout of redemption pneumonia, the flow-induced fever will certainly remain.
No Relief in Sight
If anything, flow-related problems will only worsen in the future. Flows have become “lumpier;” trends in fund ownership also suggest they will become even more volatile.
A growing share of mutual fund assets are held by retirement funds, which
experience outflows whenever participants roll over assets to a new plan or
make cash withdrawals after retirement.
[EXHIBIT 6]
With the growing dominance of wealth management platforms, asset flows are becoming larger and more concentrated. A single platform gatekeeper’s decision can move assets of thousands of investors, whether as fund inflows or outflows.
Demographics are another factor, in that aging Baby Boomers will swell the ranks of retirees making fund withdrawals.
The Trouble with Too Much Cash
As the market recovers, fund managers will be dealing not only with outflows, but also with large net inflows from new subscriptions or major platform allocations. These, too, can be challenging. Portfolio managers typically want to avoid moving markets and incurring market impact by investing assets too quickly. They may also need time to put large allocations to work in accord with their strategies. Holding excess cash in the interim can result in unacceptably high tracking error. It also runs counter to the philosophy of funds that believe in being fully invested.
The New Frontier in Fund Management
Managing the impacts of shareholder flow is still a leading-edge strategy for mutual fund managers seeking to improve fund performance. It is an idea only now taking hold in the industry, just as the notion of controlling transaction costs caught on two decades ago. This offers a potential competitive advantage to fund managers who are proactive and ahead of the trend.
