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