We will look at two case studies. Each exemplifies a point along this spectrum, with outflows at Oakmark Select
and Muhlenkamp Fund
representing the moderate end of the range and more dramatic outflows at bond funds SSgA Yield Plus
and Regions Morgan Keegan Select High Income
illustrating the extreme end. Finally, we'll also briefly touch on some of the less obvious consequences of fund redemptions, such as the negative tax consequences, increased trading costs, and the likelihood of resulting in opportunity cost risks for funds.Managing Outflows: The Moderate Cases
Bill Nygren, manager of Oakmark Select, has struggled with positions in mortgage and housing-related stocks, as the subprime-mortgage meltdown and liquidity crisis hit these areas of the market hard. Recently, positions in Washington Mutual
, Pulte Homes
, and Home Depot
have significantly hurt returns, and, thus, the fund's trailing one-, three-, and five-year relative returns look quite poor. Not surprisingly, investors have started to bail out. Moderate outflows are only a minor nuisance for most fund managers, but rapid outflows are another matter. Oakmark Select has seen just under $1.5 billion in net redemptions over the trailing 12 months--on an asset base that began around $6 billion at the start of the period.
These outflows may have forced Nygren to sell shares of stock that he would have ordinarily held, which may be partly to blame for the sizable distribution that the fund made in late 2007 (although the vast majority of this came in the form of long-term capital gains). To be sure, some of Nygren's portfolio moves last year, such as selling a piece of Dun & Bradstreet
and eliminating First Data and Mattel from the portfolio, were also responsible for the distribution, but it would seem that redemption-led sales were likely important, too. On the other hand, Muhlenkamp Fund paid out a larger distribution (about 20% of NAV) though its ouflows were steadier. The reason is that its outflows were a greater percentage of assets. The fund suffered $1 billion in redemptions off a $3 billion asset base--that's a huge one third of assets. No doubt it left Muhlenkamp with less flexibility than Nygren in managing the fund's tax situation.
In addition to tax consequences, redemption-forced sales can also increase a fund's trading costs, which can be a negative drag on total return. In fact, recent academic research
done by Roger Edelen, Richard Evans, and Greg Kadlec suggests that fund flows can have a real impact on a manager's ability to maintain strong fund performance.
However, perhaps the most important risk that redemptions can cause at value funds like these, where managers seek to take advantage of occasional mispricing and overreaction in stock market movements, is opportunity cost. During periods of dramatic volatility and stock market losses, value managers like Nygren and Muhlenkamp are often able to make purchases that can set up their funds to outperform rivals for years to come. However, in the face of significant outflows, we'd be concerned that significant redemptions will effectively disable their ability to take full advantage of declining equity markets. In other words, with minimal cash stakes, and continuing outflows, will even some of the most talented managers miss opportunities that present themselves in attractive valuation conditions?Outflows: The Extreme Cases
In the case of a large-cap stock fund like Oakmark Select, the impact of rapid outflows is real but not as dramatic as at other funds where it may be very difficult to get out of holdings quickly. A much more extreme case of asset outflows (in percentage terms, not absolute dollar values withdrawn) comes from ultrashort bond fund SSgA Yield Plus. Yield Plus was devastated by the subprime-mortgage meltdown and liquidity crisis. Over the trailing year, through February 2004, the fund has seen a 14% return loss, as compared with the typical fund in the category's 2.37% gain over that period--that's a terrible result for a fund that is supposed to be next to a money market fund in terms of safety. Over time, the fund's losses spurred redemptions, which in turn spurred more losses, and so on. The fund's assets declined from $207 million on June 30, 2007, to $35 million as of Jan. 31, 2008, or a loss of more than 80% of its asset base in roughly half a year (a combination of asset outflows and capital losses). In the third quarter of 2007 alone, the fund saw $106 million of outflows.
Why did it get so bad? The fund was forced to sell shaky mortgages at a time when no one wanted them, thus forcing management to take a steep discount. Thus, you get a vicious cycle. State Street recently replaced the fund's original managers, Frank Gianatasio and Robert Pickett, with new managers, Brett Wander and Brian Kinney, but it's not clear that the change will stem outflows or solve the trouble here.
An analogous situation to Yield Plus' quandary exists at Regions Morgan Keegan Select High Income, where manager Jim Kelsoe has long invested in more-esoteric and often less-liquid areas of the market. This has also included subprime-exposed home-equity asset-backed securities, and as of September 2007 the fund held 14% of assets in such securities. In past years investing in such issues yielded strong results with modest volatility, but when the subprime sector began its meltdown in early 2007 and broad-based illiquidity and risk aversion hit the fixed-income markets more generally, Select High Income's returns were devastated. Over the trailing year, the fund has seen a loss of 65% and has experienced outflows of $340 million in 2007. The firm's shareholder communication may also have contributed to outflows. We were initially very disappointed in the firm's inadequate explanation of the fund's troubles to shareholders, and we criticized the firm for it, but since then Regions has improved some in this area. Also, we're encouraged by the fact that the advisor has provided more than $50 million of its own capital to the fund to help stabilize the situation. Still, it's unclear whether such steps are sufficient to ultimately save the fund.Take Away
Despite the disappointing returns recently seen at Oakmark Select and Muhlenkamp Fund and the compounded difficulty of managing funds in redemption mode, we still think that these offerings represent excellent long-term options for investors. Both funds are run by veteran managers who use sound strategies and boast strong 10-year records, and both are fine stewards of shareholder capital. As a result, we think that redemptions at the funds should eventually reverse and that eventually performance will pick up.
In the cases of SSgA Yield Plus and Regions Morgan Keegan Select High Income, redemptions are much more troubling. It is highly concerning that those portfolios hold illiquid securities and that any continued redemptions could force sales that realize even greater losses. Given that investors seek stability and capital preservation from funds in the ultrashort category, we're no longer recommending that they stay the course at Yield Plus, and while Select High Income is in a category where investors might expect losses, the situation there is so extreme that it's difficult to make a case for staying.
A contrarian approach is a healthy one because it generally helps you to buy low and sell high, but be sure to check out the story on redemptions first. If a fund traffics in some less-liquid area of the market, like junk bonds or small-cap stocks, a big slug of redemptions--say 20% or more per year--is a red flag, and you may want to look for another option that invests in a similar area but with more-stable cash flows. Often larger funds hold up better because they are less likely to see a third of shareholders bolt in one year. Our research also suggests that factors such as redemption fees, designed in part to help manager flows, have fairly minimal success in stemming outflows during troubling market periods. Of course, investors shouldn't make changes to their portfolios based on redemptions alone, but it is one more data point to keep in mind when examining a fund.