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September's Mutual Fund Red Flags

Outflows could hurt these funds.

Karen Dolan, 09/11/2007

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.

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

Mutual funds are designed for the long haul, but it's comforting to know that you have the option to call your fund company on any given day before 4 p.m. and sell your fund shares that day. That kind of liquidity is a big plus in mutual fund investing. Investors have nowhere near that level of liquidity with their homes. Because mutual funds pool together the assets of thousands of investors, the typical daily inflows and outflows usually land within a manageable range.

If, however, a lot of investors run for the exits around the same time, the outflows can be very disruptive indeed by forcing managers to sell securities they wouldn't otherwise sell. It can also increase the year-end tax burden on the shareholders left in the fund. And because outflows typically coincide with downturns in a particular corner of the market, a run for the doors could force a manager to sell beaten-down securities that it would probably prefer buying in times of market weakness.

Volatility in the market has picked up, and fears seem to be spreading. For that reason, we're highlighting three funds that have faced increased and significant outflows. (Our calculation of outflows is an approximation based on the net assets at the beginning and end of a month after backing out the fund's actual performance during the month.)

SSgA Yield Plus SSYPX
Redemptions are most disruptive in illiquid parts of the market. And the market for subprime debt is a poster child for illiquidity right now. Subprime asset-backed securities are not changing hands because buyers won't touch anything related to them with a 10-foot pole. SSgA Yield Plus has been done in by some subprime securities. Although none of the fund's subprime holdings were part of the rating agencies' big downgrades, the fund has been hard hit nonetheless. Redemptions (an estimated 8% of assets in July alone and probably significant in August as well) have made things worse because they force the fund to sell into a market where most investors want nothing to do with the securities it owns. As a result the fund has suffered unprecedented losses for an ultrashort fund-significantly more than it would have if no one had redeemed.

Bjurman, Barry Micro-Cap Growth BMCFX
While the liquidity concerns that have hit the subprime market are a new phenomenon, liquidity is always an issue with micro-cap stocks. The most thinly traded part of the market is Bjurman, Barry Micro-Cap Growth's prime hunting ground. Weak performance had accelerated the outflows that were coming out of this fund in the first quarter of 2007. The fund was closed at the time, so the door could swing only one way. Management eventually reopened the fund to new investors, but the effect of the redemptions has shown up in the fund's returns. The same managers also run Touchstone Micro Cap Growth TAMCX. That fund has had much steadier flows than this one and a smaller asset base to deal with; despite a higher expense ratio, the Touchstone fund's year-to-date returns through August were 1.95 percentage points better than this fund.
 
Fidelity Real Estate Investment FRESX
This fund was still enjoying healthy inflows as recently as February when REITs were still topping performance tables. It didn't take long for that performance, and fund flows, to reverse course as the industry hit tougher times. While we've been saying for some time that investors should trim their exposure to REITs if their stake has grown larger than originally intended, we suspect some investors are fleeing only because of the recent poor performance. Fidelity skipper Steven Buller keeps a close eye on valuations and refuses to pay any price for growth. So, a weaker environment like the one we're in right now is likely to present attractive buying opportunities for the fund; yet, Buller will have a harder time scooping up bargains in the face of large outflows.

Karen Dolan is a senior analyst with Morningstar.

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