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Outflows Continue to Stream From Actively Managed Funds

Russ Kinnel explores the trend of increased outflows from actively managed funds.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Hi, I'm Christine Benz for Morningstar. We've been seeing outflows from actively managed mutual funds for some time, but that trend has been picking up steam so far in 2020. Joining me to discuss that trend and some research on it is Russ Kinnel. He's editor of Morningstar FundInvestor. Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's talk about what seems to be an acceleration in outflows from actively managed funds. You recently surveyed that for an article in FundInvestor. Let's talk about what you found there.

Kinnel: The flow story has been really interesting. As you know, active funds have long been in outflows while money goes into passive funds on the equity side. But of course, then we had this mini but severe bear market from February to March. The combination of those two certainly raises a question of funds or fund companies going away.
And the interesting trend we saw so far in flows this year is the initial reaction was selling bond funds. Somewhat understandably, muni bonds, for instance, municipal issuers are really under stress because so much of the COVID safety net has fallen to them. But then, more recently, the tables have turned. Bond funds have had inflows, and in May we saw very heavy outflows from equities, the heaviest since the previous bear market in '09.

Benz: Can you talk about what you think is driving investors to abandon ship when it comes to actively managed funds?

Kinnel: I think the passive world, mostly via ETFs but also in open-end funds, has really raised its game. They've got lower fees. There's more funds that address various corners of the market. And so in a way it's raised the bar for active funds, because you've got a lot of really good passive options at very cheap prices. So the burden's on active to justify that price. And I think more and more advisors have warmed up to ETFs. ETFs are a way for them to keep charging their fees while still lower their client's fees. So there's some really powerful market dynamics behind that move.

Benz: How about in the realm of foreign stocks? Are you seeing the trends there as well?

Kinnel: Lately, yes. In fact, as a percent of total AUM, the outflows from foreign equities was even greater in May, and I think that's largely because foreign equities have done even worse than U.S. equities.

Benz: So investors really seem to be giving up on the active foreign funds. When you survey the funds that have been getting the biggest redemptions, what commonalities do you see?

Kinnel: Well, one obvious thing is value. People are selling value because it's underperformed so much. We see a lot of the really biggest funds in outflows, though there it's really a trickle. So a lot of the giants from American Funds or Fidelity are in this steady pace of outflows. But again, if you're talking about a $95 billion fund losing $2 billion in a year, it's really not a big deal. Really I think another way of looking at it is you're seeing categories that have lots of active funds, say growth and value, having money go away and money going into blend because of course that's where the core equity index funds live.

Benz: So do you expect the fund universe to shrink as a result of these redemptions? That might seem to be sort of a logical next step?

Kinnel: It's really hard to predict because we had this severe sell-off and then this nice return rally. So it's hard to say, "Where do we go from here?" In previous bear markets, we had a slow building sell-off and then a very severe sell-off where there was a lot of despair. And so it's a little hard to say how this matches up with those templates. But I think for certain, active funds are under pressure already, and the thing that's been helping them so much in the last decade is that equities have appreciated to the point where appreciation is making up for outflows. But obviously, if say the market goes down from here, you're going to have accelerated outflows at the same time you have depreciation. And so when that happens, you're going to see really severe pressure on the active industry. Not that it'll go away, but I think more of the weaker players, more of the smaller funds, will get picked off and eliminated.

Benz: How about if I'm an investor in an actively managed fund, maybe one that I really like and want to hang on to, but it has been seeing big redemptions. What should I be concerned about? Is that potentially an impetus for me to consider selling? How should I factor that in?

Kinnel: A great question. So I think the first issue is, How big is the fund? If it's say, under $500 million or under $1 billion, then yes there's the potential for it to get liquidated. The very old rule of thumb in the industry is something like $1 to $200 million is the profitable level. But if a fund has got steady redemptions and it has poor performance, then the fund company could certainly say, "Hey, there's not much likelihood this fund will turn around soon." So that's one thing to watch for, certainly, is signs that it will liquidate. 

A more likely outcome is fees will go up because fees have their breakpoints built into actively managed funds, which mean you have lower fees if you are running more money. So they're sharing some of that economies of scale, but they bring it back when money goes out. And again, I would say if I owned a $90 billion fund, I would welcome some level of outflows. If I owned a $5 billion or $1 billion fund, I might be a little worried.

Benz: And taxes might figure into this as well. If I'm the person hanging out behind in the fund that's getting big redemptions, there could be implications for me there, too.

Kinnel: That's right. If say you have a fund that, even after the correction, still has a pretty nice, say, 10-year return and it's fairly low turnover, then those flows could cause them to sell. And the impact on the portfolio is another issue with flows--is that you could have, say, a less-liquid type of strategy. A fund might have to sell off its good more-liquid names and hold on to its less-liquid names. Or conversely it might blast through and sell its less-liquid names, but at the cost of taking a hit on price, and that could cause returns to go down, and have this cycle of more outflows. So, yeah, there are a number of negative outcomes from outflows.

Benz: Okay Russ, really interesting research. Thank you so much for being here to discuss it with us.

Kinnel: You're welcome.

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