Investors Flee Foreign Funds

Shareholder redemptions inflicted a lot of pain on stock funds in 2008, and international equity funds were among the most wounded. International stock funds shed roughly one fourth of their total assets due to redemptions from November 2007 to November 2008, according to Morningstar data. Meanwhile, U.S. stock funds lost about 10% of their assets to redemptions after accounting for market losses, while the taxable-bond and municipal-bond categories experienced positive flows for that time frame. That result isn't terribly surprising given that international stock funds generally underperformed their domestic counterparts. And with staggering losses all around for equity funds, shareholders sought refuge in fixed-income funds and/or U.S. Treasury bonds.

Although a handful of mutual fund companies have not yet reported their net flow data for 2008, we looked at some of the individual funds in the international stock category that were victims of last year's massive sell-off. The table shows funds that lost roughly 9% to 28% of their assets in addition to losses due to stock price performance.

Interestingly, the relative performance of these funds for 2008 varied. For example,  Oppenheimer Developing Markets (ODMAX) lost less than more than 80% of its peers in the diversified emerging-markets category. However, fleeing investors caused the fund's assets to drop another 27% by the end of 2008. On the other hand, foreign large-value offering  Templeton Foreign (TEMFX) and world-stock fund  Third Avenue Value (TAVFX) landed in the bottom quartile of their respective categories for the year, and a significant number of investors headed for the exits.

International-Stock Funds Most Affected by 2008's Sell-Off
	Category	Annual Flow as % of Total Net Assets*	Annual Return 2008	% Rank in Category 2008
Templeton Foreign (TEMFX)	Foreign Large Value	-28%	-46.09	76
Oppenheimer Dev Markets (ODMAX)	Div Emerging Mkts	-27%	-48.03	14
Third Avenue Value (TAVFX)	World Stock	-16%	-45.60	74
Oppenheimer Global (OPPAX)	World Stock	-16%	-41.03	43
Templeton Growth (TEPLX)	World Stock	-15%	-43.47	59
Artio International Equity (JIEIX)	Foreign Large Blend	-15%	-43.73	48
Templeton World (TEMWX)	World Stock	-10%	-39.52	34
Fidelity International Discovery (FIGRX)	Foreign Large Blend	-9%	-44.28	54
* as of Jan. 1, 2008.

The Implications Of Redemptions
So, we've seen the damage, but how can redemptions harm fund shareholders who elect to stick around? When a mutual fund is hit with a high rate of redemptions, the manager has a difficult task because most funds don't hold enough cash to meet sizable redemptions, so they must sell stocks to return cash to shareholders. Take Marty Whitman, manager of Third Avenue Value, who has built a great long-term record thanks to his expertise in distressed investing. Whitman has reported that many of his stock sales in recent months have been necessary to meet redemptions, and he's had to keep about 7% of the fund's assets in cash so that he can meet redemptions without selling stocks at extremely depressed prices. So, redemptions pose opportunity cost risk, because managers like Whitman may be selling shares of stocks that they think are poised for a rebound--just to meet redemptions.

Another difficulty that comes with managing redemptions is tax-related. When long-term holdings are sold to meet redemptions, this can trigger long-term capital gains that can be a headache come tax time. Of the aforementioned funds, a handful of them made distributions at the end of 2008; however, distributions at Templeton Foreign and Oppenheimer Developing Markets amounted to upward of 45% of the funds' NAV. So, not only were investors in these funds dealing with painful losses, they will also be dealing with a significant tax burden. Some managers choose which stocks to sell with taxes in mind. In recent months, Whitman has avoided selling core holdings, which likely have embedded gains, and instead has sold smaller positions (at a loss) to help minimize shareholders' tax burdens.

Big Cash Stakes
One way for mutual fund managers to prepare for redemptions is simply to increase a fund's cash stake. While that cash may take some of the edge off during the rough times, it can be an anchor should the markets take off. If the manager is sitting on a big pile of cash, he or she may miss out on some big gains. Thus, you need to have a certain amount of confidence that your mutual fund manager will know when to get back into the market.

Higher Fees
Another implication of redemptions is higher fund fees. Some funds' fees decline as assets increase through breakpoints that are described in a fund's prospectus. On the flip side, if the asset base shrinks, the fund's annual expense ratio may increase. A fund board can prevent breakpoints from triggering due to redemptions by instituting a fee waiver or removing the breakpoints.

Subadvised Funds and Small-Caps
Funds with multiple subadvisors can feel redemption pain a bit differently. For example,  ING International SmallCap Multi-Manager (NTKLX) lost about 50% of assets this year. The fund is subadvised by Acadian Asset Management, Batterymarch, and Schroders Investment Management North America. Acadian runs the lion's share of this fund's assets, while teams from Batterymarch and Schroders run about 25% and 15%, respectively. While new inflows are directed to the Schroders sleeve, outflows are proportional to the size of each sleeve, and all three were in net redemptions in 2008. However, as the Acadian sleeve generally underperformed the other two during the year, the Batterymarch and Schroders sleeves' redemptions were also necessary to maintain the roughly 60% of assets in the Acadian sleeve. Such a situation can make it harder for an outperforming strategy to keep the pace and can therefore be drag on overall returns.

We would be particularly mindful of redemptions at international small-cap or emerging-markets funds, as their securities tend to be more lightly traded. If a manager must sell to meet redemptions and there are few buyers for a stock that he wants to sell, it's likely that the selling fund will push down the price of the stock it's trying to unload, and that could lead to sizable losses.

How To Deal
If one of your funds experiences a potentially damaging amount of redemptions, take the time to be a well-informed investor. Simply understanding your fund manager's approach, in terms of how he manages cash and whether the fund holds less-liquid securities, can help you weather the storm. As we've noted, 2008 was somewhat of an anomaly in terms of redemptions. But we suggest that you keep an eye on any fund that experienced such high levels of redemptions (in the double digits) prior to 2008, as well as in the future. We'd consider this a warning sign, and it may be time to find a fund from that particular category that has had more stable flows. (Be mindful of the tax implications of switching to a new fund, though.)

Your fund should be explaining to you, through shareholder letters and semiannual and annual reports, how it is managing redemptions, but sadly, most funds have been mum in the recent market crisis. Many managers do not explain much about their fund's inner workings beyond quarterly performance, let alone the effect of redemptions in their letters. Among international stock funds, Marty Whitman continues to be the best example. Aside from talking in-depth about individual holdings and putting the current environment into perspective, he was upfront with shareholders in his October 2008 letter regarding the difficulties of managing redemptions.

Morningstar Investor Returns can be another helpful tool. This measure indicates how the average fund investor fared during a specific time frame. Investor returns that are higher than total returns indicate that investors have been able to use the fund well over time, and perhaps these investors are more likely to have the type of "stay the course" mentality that is beneficial to all. A few options with long-tenured managers and outstanding 10-year investor returns include GMO Emerging Markets III (GMOEX),  Lazard International Small Cap (LZISX), and  Masters' Select International (MSILX).