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From Difficult to Disaster: Redemptions' Impact on Funds

Know the cash-flow pressure your fund manager is under.

Lawrence Jones, 02/12/2008

Daily inflows and outflows present a real challenge for mutual fund managers. This situation can be difficult for mutual funds particularly because funds often see significant redemptions in periods when they have fared poorly (forcing managers to sell into markets where fund securities have been declining) and will often see inflows after years of strong performance (when, presumably, market valuations in the areas that management traffics are less attractive). Moreover, the disruptive nature of redemptions/outflows (our main focus) can range widely from merely being difficult to manage to having disastrous consequences for fund shareholders.

We will look at two case studies. Each exemplifies a point along this spectrum, with outflows at Oakmark Select OAKLX and Muhlenkamp Fund MUHLX representing the moderate end of the range and more dramatic outflows at bond funds SSgA Yield Plus SSYPX and Regions Morgan Keegan Select High Income MKHIX illustrating the extreme end. Finally, we'll also briefly touch on some of the less obvious consequences of fund redemptions, such as the negative tax consequences, increased trading costs, and the likelihood of resulting in opportunity cost risks for funds.

Managing Outflows: The Moderate Cases
Bill Nygren, manager of Oakmark Select, has struggled with positions in mortgage and housing-related stocks, as the subprime-mortgage meltdown and liquidity crisis hit these areas of the market hard. Recently, positions in Washington Mutual WM, Pulte Homes PHM, and Home Depot HD have significantly hurt returns, and, thus, the fund's trailing one-, three-, and five-year relative returns look quite poor. Not surprisingly, investors have started to bail out. Moderate outflows are only a minor nuisance for most fund managers, but rapid outflows are another matter. Oakmark Select has seen just under $1.5 billion in net redemptions over the trailing 12 months--on an asset base that began around $6 billion at the start of the period.

These outflows may have forced Nygren to sell shares of stock that he would have ordinarily held, which may be partly to blame for the sizable distribution that the fund made in late 2007 (although the vast majority of this came in the form of long-term capital gains). To be sure, some of Nygren's portfolio moves last year, such as selling a piece of Dun & Bradstreet DNB and eliminating First Data FDC and Mattel MAT from the portfolio, were also responsible for the distribution, but it would seem that redemption-led sales were likely important, too. On the other hand, Muhlenkamp Fund paid out a larger distribution (about 20% of NAV) though its ouflows were steadier. The reason is that its outflows were a greater percentage of assets. The fund suffered $1 billion in redemptions off a $3 billion asset base--that's a huge one third of assets. No doubt it left Muhlenkamp with less flexibility than Nygren in managing the fund's tax situation.

In addition to tax consequences, redemption-forced sales can also increase a fund's trading costs, which can be a negative drag on total return. In fact, recent academic research done by Roger Edelen, Richard Evans, and Greg Kadlec suggests that fund flows can have a real impact on a manager's ability to maintain strong fund performance.

However, perhaps the most important risk that redemptions can cause at value funds like these, where managers seek to take advantage of occasional mispricing and overreaction in stock market movements, is opportunity cost. During periods of dramatic volatility and stock market losses, value managers like Nygren and Muhlenkamp are often able to make purchases that can set up their funds to outperform rivals for years to come. However, in the face of significant outflows, we'd be concerned that significant redemptions will effectively disable their ability to take full advantage of declining equity markets. In other words, with minimal cash stakes, and continuing outflows, will even some of the most talented managers miss opportunities that present themselves in attractive valuation conditions?

Outflows: The Extreme Cases
In the case of a large-cap stock fund like Oakmark Select, the impact of rapid outflows is real but not as dramatic as at other funds where it may be very difficult to get out of holdings quickly. A much more extreme case of asset outflows (in percentage terms, not absolute dollar values withdrawn) comes from ultrashort bond fund SSgA Yield Plus. Yield Plus was devastated by the subprime-mortgage meltdown and liquidity crisis. Over the trailing year, through February 2004, the fund has seen a 14% return loss, as compared with the typical fund in the category's 2.37% gain over that period--that's a terrible result for a fund that is supposed to be next to a money market fund in terms of safety. Over time, the fund's losses spurred redemptions, which in turn spurred more losses, and so on. The fund's assets declined from $207 million on June 30, 2007, to $35 million as of Jan. 31, 2008, or a loss of more than 80% of its asset base in roughly half a year (a combination of asset outflows and capital losses). In the third quarter of 2007 alone, the fund saw $106 million of outflows.

Why did it get so bad? The fund was forced to sell shaky mortgages at a time when no one wanted them, thus forcing management to take a steep discount. Thus, you get a vicious cycle. State Street recently replaced the fund's original managers, Frank Gianatasio and Robert Pickett, with new managers, Brett Wander and Brian Kinney, but it's not clear that the change will stem outflows or solve the trouble here.

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