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Flows + Bloat = Headaches for Funds

Goldilocks knows there are problems with being too hot or too cold.

Russel Kinnel, 03/27/2017

The following article appeared in the February issue of Morningstar FundInvestor.

For most mutual funds, the ideal level of money coming in is a small positive inflow. It gives the managers some money to pursue new ideas with but doesn't force them into significant selling or buying. A high level of inflows or outflows, however, can be very disruptive. At a minimum, it soaks up a big chunk of a manager's day. But the real harm comes if the manager has to trade so much that it causes trading costs to soar or forces a change to the way the fund is managed--or both.

I looked for signs of harmful flows in Morningstar 500 domestic-equity funds' flows and bloat ratios. The bloat ratio is a measure that infers likely trading impact by looking at liquidity of holdings and volume of trading. Specifically, we multiply the average daily trading volume of a fund's top holdings by the fund's turnover. Essentially, you are asking how liquid is the portfolio and how much liquidity is needed based on past turnover? When bloat is high, it can mean that the strategy is pushing the limits in a way that could be costly.

I ranked the bloat ratios by Morningstar Category, as bloat presents different challenges for different strategy types. I also looked closely at the change in bloat ratio, as that is a sign that a strategy is changing either by the manager's choice or because inflows or outflows are forcing changes.

Past studies have found that the most bloated 20% of funds tend to suffer from underperformance on a pre-expense basis. I also looked closely for changes in bloat ratio as confirmation that flows are having an impact on trading costs. In this case, inflows will cause it to rise and outflows will cause it to decline. I excluded funds-of-funds and passive funds from the process because flows are much more manageable for them.

To put the bloat and flow information in context, it's best to think of them as secondary factors in a fund's performance. It's pretty rare that these are the most important factors in explaining performance; rather, they are headwinds. Occasionally, they are pretty strong headwinds. For example, a small-cap momentum strategy is particularly vulnerable to asset growth because even small amounts can drive up the prices of stocks with strong momentum. But funds with lower turnover and more-liquid stocks have greater capacity.

Our Morningstar Analyst Ratings take these factors into account. In the cases below where I point out a sign of concern but the fund is a Morningstar Medalist, that means we still think the positives outweigh the negatives. See Exhibit 1 for an overview.

Worrisome Inflows
Perkins Small Cap Value JSCVX reopened in 2015, and the fund took in $725 million to bring assets up to $2.5 billion. When it was closed, the fund suffered four straight years of outflows, so this brings it back only to where it was in 2013. That doesn't sound too bad, but it brought the fund's bloat ratio to the 94th percen­tile, so it did move the needle. A second piece of the story is that the fund held sizable cash stakes in the past, but management decided to stay fully invested in 2013 and keep cash around 5%. I think in this case it's the combination of the inflows and cash-paring that is making the fund more challenged by trading. I hope this means the fund will be as quick to close to new investors as it has been in the past.

T. Rowe Price Small-Cap Value's PRSVX manager David Wagner put up big returns in 2016, his third year at the helm of the fund. The fund gained about 29%, powered by a bevy of bank stocks, and that was enough to flip the fund from outflows in the first half of 2016 to solid inflows, netting a total of $440 million in inflows for the year. As a result, the fund's bloat ratio surged to 1.78 from 0.43, placing it in the top 3% of small-blend funds for bloat. Interestingly, the percentage of assets packed into the top 10 has come down slightly under Wagner, but turnover rose to 32% under Wagner from 16% in Preston Athey's final year running the fund. But I'm only a little worried at this point. Turnover may come down, and T. Rowe Price might close the fund to new investors again if the flow trend continues. Certainly, the fund will likely get meaningful inflows in 2017, as that 29% return will get attention.

Invesco Diversified Dividend LCEAX took in $6.7 billion in 2016, and that pushed its bloat ratio into the most-bloated decile of large-value funds from the second-most-bloated decile in 2014. I'm not too worried given that the fund is a large-cap fund with low turnover. However, it now owns four days' trading volume of General Mills GIS, five days' trading volume of The Hartford HIG, and eight days' trading volume of Suncor Energy SU. Thus, manager Meggan Walsh does have a little less flexibility than before.

Janus Enterprise JAENX closed on Jan. 27, 2017, and not a moment too soon. The fund took in $3.7 billion to become an $11 billion fund in 2016. (Manager Brian Demain runs an additional $2 billion in the same strategy, but outside the fund.) As a result, the fund's bloat ratio surged to the top 15% of mid-growth funds.

That's a lot to run in a mid-growth strategy, but I'm heartened that Demain tends to keep turnover low.

Akre Focus AKREX has stayed focused even after another $800 million in new cash pushed its total assets under management to $5.6 billion. That's more than 3 times what Chuck Akre ran at his previous fund. Here, he has actually boosted the percentage of assets in the fund's top 10 holdings to 64% from 54% since 2012. That's had little impact on the liquidity of top-10 positions Mastercard MA and Visa V, which take up just one day's trading volume, but Markel MKL and Constellation Software CSU represent 14 and 16, respectively. Akre's tendency to keep ample cash and cash substitutes on hand provides additional liquidity and lessens the worry here.--but it doesn't remove it.

American Century Mid Cap Value ACMVX is some­thing of a puzzler. It has been closed to new investors since 2013 but still took in $900 million to grow to $9 billion total. Obviously, existing investors can still drive inflows, but you don't often see that happen in a closed fund. The fund's bloat ratio is in the top 6% of the category, though it has ticked up only modestly in recent years. Its 66% turnover is higher than that of most funds covered in this article, so it's fair to say it needs a little more flexibility than most.

Parnassus Endeavor PARWX is red-hot, as evidenced by its $1 billion inflow, which accounts for a third of total assets. That inflow bumped the fund's bloat ratio up to the 92nd percentile from the 80th percentile. The fund's 63% turnover and concentrated portfolio tell me that Jerry Dodson will have his hands full. Dodson has built cash up to 16% from 3% in 2012, though I don't know whether that's because of inflows. (We do not yet cover the fund.)

Large Inflows but No Worries 
T. Rowe Price QM U.S. Small-Cap Growth Equity PRDSX drew a lot of money, but its diffuse portfolio spared it from a big shift in bloat. Despite receiving $800 million in inflows in 2016, the fund's bloat ratio rose to 0.19, which is in the 27th percentile. That's likely by design. T. Rowe Price's other small-cap funds were at or near their capacity when this fund's strategy was crafted. By having a quant strategy with a diffuse portfolio, T. Rowe created a fund with a lot of capacity and one that wouldn't tread on the favorite names of the other small-cap funds because it uses computer programs rather than analysts' work to select stocks.

American Funds American Mutual AMRMX took in $1.4 billion, but that's not such a big sum for a $42 billion fund. While the bloat ratio is in the highest decile of large-value funds, that really overstates the situa­tion at this fund, as it does at all American Funds. The reason is that American divvies the fund up among independently operating managers as well as analysts. Thus, if one of this fund's six managers decides to make General Electric GE a top holding, it still represents only a small slice of the fund. Other managers might be buying, too, or they might be selling.

Outflows Causing Greater Bloat 
Generally, inflows cause bloat and outflows lessen bloat, but that's not always the case. A manager who handles outflows by selling proportionate amounts of all holdings will reduce bloat. But another way to manage outflows is to sell the most-liquid holdings. This reduces a fund's trading costs in the short run but makes its portfolio less liquid going forward and of course changes the nature of the fund.

This leads me to Fairholme FAIRX, the fund whose bloat ratio is 8 times that of the next-most-bloated fund in the Morningstar 500. As of November 2016, Fairholme's top position was St. Joe JOE, which accounted for about one third of the company's shares and 95 days' trading volume. It also held rather illiquid stakes in Fannie Mae and Freddie Mac, which account for more than a third of fund assets combined. The fifth-largest position is Sears Holdings SHLD, which accounted for 11 days' trading volume. It was this bloat among other things that prompted us to downgrade the fund's Analyst Rating to Neutral from Silver. On the plus side, the fund does have 11% in cash, which gives some protection against outflows.

Longleaf Partners Small-Cap LLSCX is the second-most-bloated fund in our universe. It's closed, and it's in outflows, but I don't think the outflows explain the bloat. Staley Cates and Mason Hawkins just like to run the fund that way. They own about 20 stocks in this portfolio, and the top names can get pretty big. The fund's 19% cash stake mitigates some of the redemption risk, and by now shareholders must be well-acquainted with the strategy, as it has been closed for a long time.

AllianzGI NFJ Small-Cap Value's PCVAX bloat ratio has kicked up a bit, but it doesn't have the super concentration that the two funds above have. In fact, it has only 1.5% of assets in its top holding. Its bloat ratio is in the top 15% of its peer group, which is high but not that big of an issue. Rather, I'm worried about the rate of outflows. The fund shed $1.6 billion to bring it down to a $3.7 billion fund. This is an example of a fund where flows can have a very negative impact on trading costs. 

It's not a high-turnover strategy, but you have no choice but to sell when you get a lot of redemptions. I'd imagine the outflows will continue because the fund has lagged peers and benchmark alike for five straight calendar years. Most of its top holdings account for two or more days' trading. 

Outflows With Less Bloat 
Columbia Acorn ACRNX has suffered sizable redemp­tions for years. The good news is that its bloat ratio has improved during the past few years. It is now in the 90th percentile instead of the 98th. The bad news is that it is under tremendous selling pressure. The fund is down to $4.8 billion, and outflows haven't eased up. That's quite a challenge for managers running a strategy that is equal parts small-cap and mid-cap. We rate the fund Neutral in part because of that chal­lenge. The fund did manage decent returns in 2016, so perhaps that will be enough to stem the tide of outflows. 

Royce Opportunity RYPNX has seen its bloat ratio decline sharply as it is all the way out of the top quartile now. It endured $400 million in outflows last year, but at least it would appear to be better posi­tioned to manage flows in 2017. Managers Buzz Zaino and Bill Hench have built a diffuse portfolio of more than 200 names. 

The Least-Bloated Portfolios 
At the bottom of the bloat list are smaller funds with low turnover and generally diffuse portfolios. Auxier Focus AUXFXAmana Income AMANXHarbor Mid Cap Value HIMVX, and Sterling Capital Stratton Small Cap Value STSCX boast bloat ratios in the bottom quartile of their categories. Each of these funds has less than $1.5 billion in assets and therefore plenty of flexibility.

Russel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. (Click here for a free issue). Mr. Kinnel would like to hear from readers, but no financial-planning questions, please. Follow Russel on Twitter: @russkinnel.

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