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Can Passive Investing Hurt Your Actively Managed Funds?

The flow of assets to passive strategies is leaving some active funds saddled with sizable potential capital gains, style shifts, and the possibility of closure, says Morningstar's Russ Kinnel.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Mutual funds have been losing assets at the expense of exchange-traded funds. Joining me to discuss that trend is Russ Kinnel--he is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: You discussed this phenomenon in the most recent issue of Morningstar FundInvestor. You say that there is obviously something going on in the world of actively managed mutual funds. Let's talk about this trend where we've seen investors swapping actively managed funds, in particular, for ETFs. Can you quantify that for us?

Kinnel: We're really seeing an unprecedented level of outflows at actively managed funds. I was looking at the Morningstar 500 and found that 17 of the 500 had outflows of more than 50% in the trailing 12 months.

Benz: So, the Morningstar 500, those are generally some of the biggest funds out there.

Kinnel: The biggest, best, and most well-known names, and another 80 of those 500 had outflows of at least 25%. So, it's a really dramatic level of outflows from a wide swath of funds.

Benz: You pointed out in your article that this is remarkable given that we've come off a period of relatively strong performance. So, investors don't seem to be necessarily responding to losses in those funds; it's really that consumer preferences are shifting, and investors are increasingly gravitating to ETFs.

Kinnel: That's right. The market has had a bit of a downtick, but compared with previous bear markets where you might, say, lose 40% or 50% of your value--at times like that, the outflows are understandable--these were already under way before even the last few months of sell-off. So, really, it is unprecedented. You see people are being less patient with an underperformer and sometimes even selling funds that are performing pretty well.

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Benz: You point out that this isn't entirely bad. Overall, the trend toward ETFs has pushed down expense ratios throughout the asset-management industry, so that's a plus. You've also talked about how some good-quality funds have reopened for the first time. But let's talk about what investors should be thinking about as they evaluate outflows at various funds. You brought some specific funds that you think are good illustrations. Let's start with the poster child of when outflows can be a problem, Third Avenue Focused Credit, which is a fund that imploded back in 2015.

Kinnel: That's right. When you think about outflows, the biggest impact you want to look at first is liquidity issues. Are the outflows making the manager sell their holdings at a loss? You can have a negative spiral in which they take more losses because of selling as a result of outflows, and then they have to sell some more. It has this really negative spiral. We've seen that a few years in the history of funds, and the Third Avenue fund was an extreme case because they had to more or less prevent any more redemptions--or any more money going in, for that matter--because they had some really illiquid, low-quality bonds, many of which were either near default or in default. So, they called a halt. They tried to shut the fund down completely, but instead they are kind of in this unusual state where no one can get in or out. They are making periodic disbursements, and the point of doing that is to enable them to gradually sell. But that is, as you say, the worst-case scenario. Very, very few funds are likely to find themselves in that position. But it is a good example of one of the things you worry about most when you see redemptions.

Benz: PIMCO Total Return (PTTRX), I think, is a good counterpoint to that Third Avenue situation in that it, too, had very sizable redemptions--certainly in dollar terms, maybe not as a percentage of its assets. But its redemptions were sizable, and yet it seems to have managed through them.

Kinnel: That's right. In dollar terms, it was unprecedented by order of magnitude and really unusual to see. And yet PIMCO Total Return, which invests almost primarily in high-quality bonds, lots of derivatives, and had been building cash even before Bill Gross' departure because it was already in outflows, it has handled redemptions very well. You can see by looking at the total return that it's performed pretty well. We've modeled it to see how performance would be if there were no outflows, and it's been very tight on that model, which suggests that outflows have had a very small impact. So, that's a helpful guide right there for bond funds: If it's a high-quality bond fund, it's probably not a big deal if it's got big outflows or even big inflows for the most part. And as you move lower and lower in quality, there can often be less liquidity. If you have a more-focused portfolio, that can be a concern, too. That was other issue with Third Avenue; it had a lot of concentration. Typically, junk-bond funds do not have a lot of concentration, partly for that reason.

Benz: Let's discuss some of the equity funds that have seen outflows. In your FundInvestor cover story, you looked at funds that saw big outflows as a percentage of their assets. Manning & Napier Equity (EXEYX) was at the top of the list in terms of those percentage outflows. Let's talk about the situation there.

Kinnel: Manning & Napier is a shop we like, but they got energy wrong, and it has really hurt their performance and their funds in recent years. We're seeing that reflected in the outflows at this fund and at a number of their other ones. The good news here is that I don't think it's going to have a big impact on returns in the near term because Manning & Napier Equity is a large-cap-focused fund and because it wasn't that big of a fund to begin with. It would take a lot of dollars to impact large-cap stocks, so I don't see a short-term impact. Longer term, we're certainly going to want to watch the firm because there can be some negative impacts on the firm itself from that. For instance, occasionally you'll see layoffs or other things--

Benz: People quitting.

Kinnel: Right. It can be demoralizing as well. We're a little early stages for that to be a concern, but it's something you want to watch.

Benz: Another equity fund that appeared high on your list was Buffalo Small Cap (BUFSX) in terms of having a big percentage of asset outflows. Let's talk about that one. It seems like you are a little less favorably disposed toward that one.

Kinnel: That's right. In equities, it really goes large to small, so I worry much more about outflows in a small-cap fund like Buffalo Small Cap because there's less liquidity and you can have that feedback loop of flows and performance. On top of that, there has been manager turnover at the firm. So, there are a number of warning signs, which is why we've got it rated Neutral.

Benz: One other thing that you say that people should keep an eye on is whether outflows could force changes at an operational level. I'd like to take a closer look at a couple of Artisan funds that have recently announced that there will be a merger. Let's talk about that and how you think that can be reflective of some issues that can go on when there are big redemptions in funds.

Kinnel: That's right. Their value team has had a rough go of it the last couple of years after having a really great run. They have a large-cap, mid-cap, and small-cap fund--all of them are in redemptions. They just recently announced that they are going to merge the small-cap fund into the mid-cap fund. That's another thing that can happen when you have redemptions--you can have a fund merged away even though they've still got a pretty good team there. Now something different is happening, so if you bought that fund for small-cap exposure, obviously you are not going to maintain that small-cap exposure.

Benz: So, in terms of broad takeaways, first, can you give viewers a little coaching on how to keep track of asset flows in and out of their funds? What's the best way to do that?

Kinnel: Well, on Morningstar.com, you can pull up a one-page PDF and see year-on-year assets. You can look for significant changes in that. You can obviously also look for that in the shareholder report as well and, of course, in our analyst reports. If we think flows are a significant issue, our analysts are going to highlight that. There have been a number of funds where flows are a big enough concern that that's been a part of why we've lowered a fund's rating. So, there are a few different ways to get a handle on what the flows situation is.

Benz: And just to review, some of the commonalities among situations that would be most concerning would be if the fund traffics in less-liquid securities--maybe it's a small- and mid-cap product. Are there any other types of products where I should be more concerned about big outflows?

Kinnel: Certainly high yield. Beyond that, a focused portfolio occasionally can be an issue. Also, look for taxes because we have the unusual situation where we've had a nice stock rally and we have redemptions. So, what that can mean is if there is a big tax overhang in the portfolio and they have to sell to meet redemptions, then they are going to pay out a capital gains distribution among a smaller pool of shareholders. So, you might have a big tax distribution going in. If you are thinking about being contrarian and buying one of these funds in outflows, at least check the potential capital gains exposure, which is on the Tax tab of Morningstar.com.

Benz: Or maybe hold the fund in your IRA versus--

Kinnel: Right. Hold it in your IRA where it's not an issue.

Benz: Russ, thank you so much for being here to discuss this issue.

Kinnel:  You're welcome.

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

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Russel Kinnel has a position in the following securities mentioned above: PTTRX. Find out about Morningstar’s editorial policies.