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Should You Buy or Sell Funds Based on Flows?

Christine Benz
Dan Culloton

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. What impact do fund inflows and outflows have on a fund's prospects? Joining me to discuss some research on that topic is Dan Culloton--he is associate director for equity manager research for Morningstar.

Dan, thank you so much for being here.

Dan Culloton: Thanks for having me, Christine.

Benz: Dan, you looked closely at this topic in the recent issue of Morningstar FundInvestor. Let's talk about the types of funds that you looked at when conducting this research and also how you managed a fund's subsequent success or failure. What did you look at?

Culloton: We looked at domestic and foreign funds. We looked at large-cap, mid-cap, and small-cap domestic funds, and then large-, small-, and mid-cap foreign funds. What we did is we broke them down into deciles by inflows and outflows, with the first decile being the funds getting the most outflows--or least inflows--and the tenth decile being the funds getting the most inflows. Then, we took all of the funds at the start of rolling three-year periods starting in 2006 to the end of 2014 and looked at subsequent three-year performance after that. We looked at absolute returns; we looked at star ratings; we looked at success ratios, which are the odds of a fund surviving and outperforming their peers over the subsequent period.

Benz: So, there are no bond funds in the mix; you just stuck with equities.

Culloton: No bond funds--just domestic equity and foreign equity.

Benz: Let's start with the funds that were garnering big inflows over these various time periods. In terms of their success rate, let's start there and talk about how likely the funds getting the biggest inflows were to survive--one would guess probably pretty likely if funds are gathering a lot of assets--and also how likely they were to outperform their peers.

Culloton: You're right. Very few fund families want to kill off a fund that's collecting lots of assets. So, their survival rates were very high--higher than 80% or 85% in most categories. Big inflow-getters were more likely to be around over the subsequent periods. Their odds of surviving and outperforming, though, were a lot lower. The actual success ratios--which, once again, includes the odds of surviving and outperforming peers--were lower than 40% among most of the categories (for the domestic large, small, and mid, as well as the foreign large cap).

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Benz: Equity-fundholders, often, are told to being more concerned about big asset inflows if they own some type of a small- or mid-cap fund. Did you see that those funds' success ratios and the likelihood that they would outperform were meaningfully worse than you saw with large-cap funds?

Culloton: Across the board, we saw that the subsequent performance for funds in the highest-inflow decile moderated significantly. So, yes. And it was particularly acute in the small- and mid-cap domestic categories as well.

Benz: But you didn't see that as much among the foreign small- and mid-cap funds?

Culloton: Not as much, but it was there.

Benz: Switching over to the group of funds that saw big outflows: This has been top of mind for a lot of investors recently because we have seen a lot of funds--especially actively managed funds--experience big outflows. Let's talk about the success rate for those funds that were seeing the biggest outflows over the time periods that you looked at.

Culloton: This was very interesting because, as you might expect, the odds of those funds being around in the subsequent three-year periods were a lot lower. Their survival rates were very low--the success ratios were in the 20% to 25% range.

Benz: So, getting killed off is a big risk for those funds that are seeing big outflows.

Culloton: Right. But what's interesting, though, is that oftentimes in these categories the absolute returns of the funds that did survive were better than the returns of the funds that were getting big inflows. So, for instance, in the domestic mid-cap and domestic small-cap area, the biggest-inflow deciles returned about 9% or 9.5% over subsequent periods, while the biggest-outflow deciles returned 10% or 10.5% on average. Survivorship bias probably has something to do with that, with the bad funds getting killed off. But it might also imply that if you stick through the outflows--if you have a strong reason to believe that that fund will be around over that time period--you might actually get a better result.

Benz: So, if you don't think it will be merged away or liquidated or something else, you might actually view outflows as a contrarian indicator in a way.

Culloton: If you have a strong reason to believe that the manager of that fund is the master of its own destiny and will be patient enough and can be patient enough because of its culture or its business attributes to stick with that strategy through the outflows, then there may be a good chance that it survives and turns in better returns later.

Benz: In the Morningstar FundInvestor article, you highlighted a few funds that have had big outflows and inflows recently. You didn't look at them on a backward-looking basis, but let's start with a couple of the ones that you highlighted that have seen big outflows recently.

Culloton: The first one we highlight is Columbia Acorn (ACRNX) and, like most of the funds that we highlight, its outflows have been in the bottom decile over the trailing one and three years. So, it has experienced more outflows than better than 90% or 99% of its category peers over the trailing one- and three-year periods. It's been in a performance slump, but this has really been the least of its worries. It's had a lot of internal change. There has been some manager change at the fund. There has also been some change on the analyst staff and some reshuffling of the analyst staff at the firm in general. This is still a big fund. It actually might qualify as a fund that is master of its own destiny--

Benz: How so, though? It has had the manager changes.

Culloton: Well, it's a $15 billion fund. Columbia Wanger Asset Management is still a large firm with a fairly large staff. There has just been a lot of reshuffling. It's not a matter of whether this fund or this firm is going to exist in the next three years. But the outflows don't make its job any easier right now.

The other fund that we highlighted as experiencing significant outflows is Royce Pennsylvania Mutual (PENNX), which is also a fund with a long track record. There's a much more stable management situation there, but it's also experienced outflows of $3.5 billion over the past three years, which is something to watch.

Benz: In terms of funds that have seen big inflows recently, let's talk about one that you and the team are watching from the standpoint of what those inflows could potentially mean for performance.

Culloton: A fund that we recently brought under coverage, Eventide Gilead (ETGLX), has put up tremendous performance numbers and has a very interesting ESG strategy.

Benz: Could you say what that means?

Culloton: It [stands for environmental], social, and governance strategy. It's a socially responsible fund with a strong bias toward tech and biotechnology. It has done very, very well with a very unique strategy and has gathered significant assets. It's growing faster than about 95% of other mid-cap growth funds.

This can also be a red flag because it's very concentrated sector-wise, it's fairly concentrated issue-wise, and it has invested in areas where performance has been very, very strong--particularly in biotechnology. So, that's an area that it might pay to keep a close eye on. Before jumping in, try to ask yourself, "Is this type of performance sustainable for the long term?" In fact, we give it a Neutral rating because, even given all of its positive attributes, it hasn't seen a full market cycle yet.

Benz: In terms of takeaways for investors monitoring their own basket of holdings--some of which may be seeing big inflows, some of which have perhaps seen outflows--what are the key pieces of advice that you would impart, based on this research?

Culloton: I would say, first, recognize that inflows and outflows can have an impact on the performance of your fund, but it's not necessarily an automatic buy or sell signal. You have to, as always, understand what you own and, at least in this case, understand whether that fund or fund family is master of its own destiny. Say you own a fund at a family that has a history of chasing trends and starting a lot of funds and killing off a lot of funds; if one of their offerings is being hit by outflows, you might have a lower degree of confidence that that fund is going to be around, going forward. But if you own a fund at a shop that takes a much more considerate approach to fund development and has a reputation for closing funds when they get too large or when inflows get too hot, then you might have more confidence that that fund will survive and turn in competitive results, going forward.

Benz: Dan, really interesting research. Thank you so much for being here to share it with us.

Culloton: Thank you.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.