Anatomy of a Mutual Fund Disaster
How redemptions and illiquid market conditions conspired to devastate two funds.
Unlike their closed-end and hedge fund counterparts, open-end mutual fund managers must deal with daily asset flows into and out of their funds. Cash flows can be tricky for managers to handle even in the best of times, but managers often see significant redemptions in periods when their funds have fared poorly, forcing them to sell into markets where fund securities have been declining in value. Inflows, on the other hand, often occur after years of strong performance, presumably when market valuations in the areas that management traffics are less attractive.
Although difficult, many managers are adept at navigating their funds through these disruptions. Occasionally, however, dramatic swings in cash flows can have disastrous consequences for managers and fund shareholders. We will look at two recent cases that exemplify the extreme of what can happen on the redemption side of the equation--when masses of shareholders flee a fund during a tough market. We'll also point out some red flags to help avoid funds that are in poor positions to withstand a torrent of outflows.
Like Water in the Serengeti
Liquidity, as Warren Buffett once suggested, is often taken for granted until it's no longer there. It also matters greatly when determining the impact that redemptions can have on a portfolio. Unlike large-cap equity funds, which buy securities in one of the most liquid markets in the world, fixed-income funds sometimes trade in securities that may be very difficult to get out of quickly.
The 2007-08 subprime-mortgage meltdown and liquidity crisis is only the most recent example of bond market illiquidity (albeit an extreme case). In a classic flight to quality, investors became wary of making risky credit-quality bets and fled sectors such as high yield, bank loans, asset-backed securities (particularly subprime-exposed bonds), and troubled financial sector corporate debt. Liquidity for bonds in these markets evaporated as risk-averse investors shifted assets away from regions of the market perceived troubled toward areas thought safe (which drove strong returns in U.S. Treasuries and TIPS).
For mutual funds that remained in riskier areas, however, few things could be more dangerous than being forced to sell into a declining and illiquid market to meet shareholder redemptions. But that's exactly what happened to SSgA Yield Plus and Regions Morgan Keegan Select High Income (MKHIX).
Redemptions and Illiquidity Don't Mix
Markdowns in its asset- and mortgage-backed securities demolished the record of SSgA Yield Plus, an ultrashort-bond fund. (Many of its subprime-exposed holdings were originally rated AA and AAA.) In the year before it was ultimately liquidated, the fund saw a greater than 20% loss, a terrible result for an offering that was supposed to be close to a money market fund in terms of safety.
During the past year, the fund's losses spurred redemptions, which in turn spurred greater losses, and so on. Combined, outflows and capital losses drove the fund's assets down to $28 million by early 2008, from $207 million on June 30, 2007, a loss of more than 85% in roughly half a year. In the third quarter of 2007 alone, the fund saw $106 million in outflows, as managers were forced to sell shaky mortgage-related securities at a time when few wanted them. The managers likely were forced to take deep discounts on their holdings to meet redemptions.
State Street replaced managers Frank Gianatasio and Robert Pickett with new management, with Brett Wander and Brian Kinney taking the lead. Shortly thereafter, though, the firm announced the liquidation of the fund, to be completed near the end of May 2008, so this offering has become another casualty of the subprime crisis.
Meanwhile, the situation wasn't any better over at the high-yield bond fund Regions Morgan Keegan Select High Income (and at other bond funds run by the same advisor). Manager Jim Kelsoe has long invested in more esoteric and often less-liquid corners of the market. In September, the fund held 14% of assets in subprime-exposed home equity asset-backed securities. In past years, investing in these types of issues yielded strong results with modest volatility. In the current environment, however, anything related to the subprime sector meant trouble, and Select High Income's returns were devastated. Over the trailing year, through July 7, the fund lost 77%, and it experienced outflows of $340 million in 2007. By June 30, 2008, the fund was left with a mere $52 million in assets, down from $1.2 billion in late 2006.
The firm's shareholder communication may also have contributed to outflows. We were initially very disappointed by the firm's inadequate explanation of the fund's troubles, and we criticized the firm for it. And while we were encouraged by the fact that the advisor provided more than $50 million of its own capital to the fund to help stabilize the situation, it's clear with hindsight that the action was insufficient to ultimately save the offering. In the end, the fund's advisor, Morgan Asset Management, sold this offering and several other troubled open- and closed-end funds to Hyperion Brookfield Asset Management, with the shareholder-approval proxy set for later this week. While we're glad to see new eyes looking to resolve this highly troubled situation, we think it's an open question as to whether the funds are ultimately salvageable.
Red Flag of Redemptions
The lesson here is that investors need to keep liquidity risk in mind when selecting fixed-income funds. If a fund traffics in less-liquid areas of the market (or areas that could become illiquid, although this can be difficult to determine in advance of market disruptions), such as junk bonds or asset-backeds, a significant redemption rate--say, 20% of assets or more in a quarter--is a serious red flag. You may want to look for another option that invests in a similar region of the market but that has more stable cash-flow characteristics. Often, larger funds hold up better because they are less likely than small funds to see a third of their shareholders bolt in one year. Our research also suggests that factors such as redemption fees, designed in part to help manage flows, have minimal success in stemming outflows during troubled markets.
Finally, another point to consider is how the possibility of potential redemptions could impact a fund. For instance, Metropolitan West Strategic Income (MWSTX) has suffered along with others over the past year because of its positions in mortgage-backed securities and subprime-related asset-backeds that have been hurt in recent markets. Even more concerning, however, is the fact that regulatory filings show that a single institutional account comprises near 80% of assets in the fund's institutional share class (MWSIX), which itself constitutes 86% of total fund assets. In other words, should that client depart, it could well put fund management (and remaining shareholders) in a precarious position. On the other hand, if that client stays put, shareholders don't have to worry about redemptions crippling the fund. Fortunately, in this case, we think that the fund's advisor is talented and that management has good experience in dealing with difficult market situations. While we don't think that investors should make big changes to their portfolios based on redemptions alone, and certainly not solely on the prospect of possible future redemptions, these are items to keep in mind when examining a fund for purchase and in deciding whether to stay the course.
This article was adapted from the Spring 2008 Bond Fix column in Morningstar Advisor magazine.
Lawrence Jones does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.