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May 2008 Mutual Fund Red Flags

These funds are suffering from a tidal wave of redemptions.

Karen Dolan, 05/20/2008

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

Outflows are typically a nuisance for fund managers who have to sell more than they are buying, but they can become a real destructive force when trading volume for the fund's holdings dries up. In that case, selling causes losses as the fund's traders have to offer fire sale prices in order to find a buyer. In the last 12 months we've seen a sharp increase in cases of destructive redemptions that have turned poor market returns into awful. The following four funds have seen a huge pickup in outflows. Have these funds' outflows crossed the line into the destructive kind? Read on.

Schwab YieldPlus Investor SWYPX
This fund has been knocked off kilter with outflows. We estimate that it has seen roughly $9.1 billion (about 76% of its asset base) walk out the door in the past year. The heavy redemptions aren't surprising given the shocking losses investors have faced. The fund has lost 26.6% over the past year through April 17, 2008--that coming from a fund that was supposed to provide a risk/return profile slightly higher than cash but still relatively safe compared with other assets. The fund held heftier stakes in hard-hit corporate and nonagency mortgage bonds than its typical peer, and management underestimated the potential volatility of those holdings. It didn't take more than a couple percentage points of losses before many bolted. In order to meet those redemptions, the fund was forced to sell securities at steep losses, which makes the chances of a full recovery slim to nonexistent and the argument for sticking with it null as well. We made the fund a pan because it's clear that redemptions are making things worse as the fund has ticked down almost every day.

Fidelity Floating Rate High Income FFRHX
This fund has seen almost half of its asset base exit in the past year as just about every bank-loan fund has faced heavy redemptions. But the level of outflows seems out of sync with the fund's capabilities, and we think it's out of sync with what its future holds. This has been one of our favorite funds in the bank-loan category since we first selected Fund Analyst Picks for the group in 2004 and it has only proven its worth lately. Its approach has been just the ticket since the bank-loan market seized up in mid- 2007. The entire loan market has struggled, but lower-quality, less-secure fare has done worse, so the fund's avoidance of such issues has helped. And, as the fund has been hit by redemptions--as have all bank-loan funds lately--the manager's emphasis on more-liquid loans has helped her to sell off positions piecemeal and maintain the portfolio's weightings in her favorite issuers and sectors. In all, the fund has lost ground in the past 12 months, but its 0.53% loss is one of the smallest in the category. Thus, the fund is proving its mettle in the face of outflows.

FPA Paramount FPRAX
This fund's shareholders have been heading to the exits lately, yanking out roughly $250 million (or 43%) of the fund's assets in the past year. They've done so amid what looks like a rough stretch of relative performance, but some perspective is in order. The fund's low-turnover but valuation-sensitive strategy leads it to perform rather differently from mid-growth and mid-blend funds. We think it can earn its keep over the long haul. We're not concerned about outflows weighing too heavily on the fund or its returns.

Harbor Large Cap Value HILVX
A total of 73% of this fund's assets have left in the past year. That may be partly in response to the June 2007 management change or the lackluster performance leading up to it. In addition, the fund made a huge capital gains payout after the management change, and investors may have opted to hold on to the payout rather than reinvest. Those outflows are a lot for a new manager to have to swallow, but the fund travels in liquid large caps and the absolute amount of assets is still manageable. Outflows bear watching, but we're not too concerned at this point.

Karen Dolan is director of fund analysis with Morningstar.

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.


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