Is Your Fund Under Pressure From Outflows?

Do you own a fund where performance is slumping and money looks like it’s flying out the door? It’s probably worse than you think. A robust stock market rally in 2023 might have lifted your fund’s total assets and masked the amount of outflows.

Outflows can cause four different problems. First, they can cause fees to rise since many fees are based on assets in the fund. Rising asset levels trigger breakpoints that share efficiencies with shareholders, but the opposite is true when money flows out. Second, outflows can force managers to sell stocks at a rapid pace and cause the prices of holdings to fall further, thus boosting losses. Third, they can cause capital gains distributions. Fourth, they can lead a fund company to merge a fund away as it becomes less profitable.

We calculate an organic growth rate for a fund by backing out appreciation or depreciation to reveal the flows relative to the beginning asset base to show just how much the fund is growing or shrinking outside of market effects. At one end, we have a Morningstar FundInvestor 500 fund that grew by 106% in 2023, and at the other, we have one that shrank by 82%. Most changed by 10% or less, but let’s look at those that are at the extreme ends of flows to understand how they are doing.

I’ll focus on equity funds because flows are generally manageable for bond and allocation funds.

Diamond Hill is a fundamental value shop that we like, but investors are falling out of love with it. Three of the firm’s four funds in the Morningstar 500 have three-year returns in the bottom quartile, and two have bottom-quartile returns for the trailing five years. Overweightings in real estate and industrials have hurt, as has exposure to regional banks like Silicon Valley Bank. Diamond Hill Small-Mid Cap DHMAX and Diamond Hill Mid Cap DHPAX each endured negative 82% organic growth rates in 2023, while Diamond Hill Large Cap DHLAX had a growth rate of negative 67%. The firm’s one decent performer, Diamond Hill Small Cap DHSCX, dwindled 34%.

Diamond Hill Small-Mid Cap is the one where flows concern me the most. Small caps and mid-caps are somewhat liquidity-constrained, and in absolute terms, the fund had $451 million in outflows in 2023. That’s a pretty large amount of stocks to sell. It’s quite possible that some of the fund’s calendar-year underperformance was due to outflows depressing the prices of the fund’s holdings as manager Chris Welch steadily sold to meet redemptions. But the good news is that Diamond Hill pulled the lever it had to curtail outflows. In October 2023, it reopened the fund to new investors. After the fund’s outflows had spiked to $236 million in September, they fell to just $13 million in October, presumably because new cash came in. The fund finished the year with modest outflows of $62 million in November and $28 million in December.

Although Diamond Hill Mid Cap had the same negative growth rate, I’m less concerned because it’s a small fund, and it only suffered $39 million in net outflows. Maybe the greater concern here is that the fund’s small asset base could lead the firm to merge it away.

Diamond Hill Large Cap faced substantial outflows, but large caps are liquid, and managing flows is rarely a problem for a large-cap fund. Diamond Hill Small Cap had more modest outflows and better performance, so it is not a concern for me.

If you own a Diamond Hill fund, it’s worth keeping tabs on flows. But 2024 performance will probably be the more telling data point. A strong year should slow flows significantly. However, another poor year could accelerate outflows and increase pressure on managers.

It’s been a rough three years for T. Rowe Price Emerging Markets Stock PRMSX. The fund, which has a Morningstar Medalist Rating of Bronze, significantly underperformed peers in each of the past three calendar years. China played a big part in those poor results, as did a market that leaned toward value in 2022. Manager Eric Moffett took over in January 2022, so he only owns two of the three lean years, but shareholders are still rushing for the exits. The top of the portfolio has liquid names like Samsung, but there are some smaller-cap names lower in the portfolio. The fund had four consecutive years of redemptions totaling more than $1 billion, and its organic growth rate was negative 62% in 2023. We like the manager and strategy, but outflows look to be a serious headwind that only some strong performance will cure.

American Beacon International Equity AAIPX had an organic growth rate of negative 48% last year, but that’s less concerning than the above funds’ outflows. The fund is spread among three value subadvisors: Causeway, American Century, and Lazard. That makes the portfolio very diffuse, and the top holdings are fairly liquid large caps. In addition, the outflows are large in percentage terms, but selling $560 million in large-cap foreign equities over the course of a year shouldn’t be too hard. Finally, the fund produced a nifty top-decile return in 2023, so outflows should be slowing at this Bronze-rated fund.

LSV Value Equity LVAEX is another slumping value fund facing redemptions. Its recent returns were middling, but the five-year number was on the cusp of its Morningstar Category’s bottom quartile, and that resulted in an organic growth rate of negative 44%. The good news is that this quantitative fund invests in large caps and only has about 2.4% of assets in its top holding. So, outflows are not too concerning at the moment.

Matthews Asia Dividend MAPIX faced a headwind of a negative 37% organic growth rate in 2023 that owed to a long-running slump. In response, the firm changed managers as part of yet another round of changes. In January 2024, we took the fund’s People rating down to Average, and the fund now sports a Negative Medalist Rating. We also lowered the Parent rating to Average in June 2023. The fund does invest in stocks with a mix of liquidity, so outflows are a concern, but we’re more worried about the run of personnel and strategy tweaks. Should these changes not work out, outflows will likely continue—if not get worse.

Matthews Asian Growth and Income MACSX had an organic growth rate of negative 31%. But there is some good news here. Unlike Matthews Asia Dividend, this fund’s management team and strategy are stable. The fund’s Bronze rating underscores that and may help to keep flows from getting worse. The more modest outflows indicate it’s less of an issue.

Small value is the least liquid corner of the stock market, so it’s never welcome to see outflows at a fund like Boston Partners Small Cap Value II BPSCX. The fund’s organic growth rate was negative 32% because the fund has produced consistently sluggish results, but generally, the results were just a tad below the category average. The fund’s defensive nature tends to help in weak economies, and recent strong growth might not put it in the best light. Still, it did break out of its downtrend for a solid result last year. In the last three months of 2023, outflows for each month were below $10 million (versus outflows of $176 million in the preceding nine months), so right now things look good, provided there are no pratfalls in 2024.

Alas, things are trending the wrong way for Alger Small Cap Focus AOFAX. We recently downgraded the fund to Bronze as performance has been brutal for the past three years. The fund suffered outflows of greater than $100 million a month in November and December. That’s a lot for Amy Zhang and team to handle as they try to right the ship. We still have confidence in Zhang and her strategy of patiently investing in fast-growing but generally profitable companies. But outflows are not helping at all.

I guess it’s sort of good news that Jackson Square SMID-Cap Growth JSMVX had an organic growth rate of only negative 31%. I mean, a look at recent returns and I’d have guessed double that amount. Over the past two years, it lagged its category index by a huge 1,200 basis points, giving it bottom-percentile returns for the trailing five years—even though that period includes the fund’s huge 64.5% gain in 2020. Shareholders have largely stuck with the fund, but will they stay on board with that track record?

Conclusion

The Medalist Rating reflects our long-term assessment of a fund’s prospects, so you can see that we think most of these funds can overcome the challenges of outflows. I’d suggest watching flows and performance to see how they’re shifting. If your fund continues to slump, it will face a more difficult road back to investors’ good graces.

This article first appeared in the February 2024 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting this website.