Redemptions look like a lose-lose situation for everybody.
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By Karen Dolan, CFA | 10-23-08 | 06:00 AM | Email Article

Investors have been selling their mutual funds in record numbers. According to Morningstar's Market Intelligence data, a net amount of $49 billion left mutual funds in September alone. We've been tracking redemption data since January 2000, and that's the largest one-month outflow that we've seen to date. Yet, it looks like October is on pace to beat it. Looking at the first half of this month and only the portion of the mutual fund universe that has reported asset figures to us, we believe a more severe outflow picture is brewing for October. The heavy redemptions are likely due to the widespread losses that haven't been isolated to a few asset classes but have spread to more conservative asset classes and funds.

Karen Dolan is director of fund analysis with Morningstar.

The heavy redemption activity that we've seen has implications for funds and shows a repeat of investor behavior that seems unlikely to pay off for anybody.

Lots of Redemptions and Little Cash
Many funds are carrying a small amount of cash and, at the same time, facing large shareholder redemptions. The average domestic equity fund held just less than 5% in cash as of its most recently disclosed portfolio. That means that they have little dry powder sitting around on the sidelines with which to buy depressed securities and meet redemptions.

Even if opportunities are plentiful (which many well-respected fund managers and industry pundits argue is the case), a fund facing redemptions is restricted in its flexibility to do much about it. If you're a mutual fund manager in this position, you have to sell more than you can buy, which is far from ideal when you're finding a lot more to buy than to sell. Different managers are dealing with this in different ways. Many have eliminated smaller holdings and concentrated more of the portfolio in their highest conviction picks. Others have been trying to hold more cash on hand in anticipation of redemptions. 

Yet, trading costs rack up with those forced transactions. Academic research* on the topic has shown that fund trades motivated by shareholder cash flows are more costly than voluntary trades motivated by research. At its worst case, depending on the liquidity of holdings in the portfolio, redemptions can trigger a vicious cycle that can really drive down a fund's value. We've seen that risk turn ugly during the past year with ultrashort bond funds such as Schwab YieldPlus and Fidelity Ultra Short Bond. The funds experienced some losses early on, which triggered redemptions that forced them to sell securities into an illiquid market, which locked in further losses, which invited more redemptions, so on and so forth. Such drastic illiquidity has been more of an issue with bonds (excluding Treasuries) than with stocks.

The Beauty of the Mutual Fund Structure Is Part of the Problem
Mutual funds are exposed to this risk because of the investor-friendly structure that makes them so appealing in the first place. They are an inexpensive, transparent, accessible, and well-regulated way for investors of all stripes to gain access to professional money managers and build diversified portfolios. In addition, investors can sell their funds on a daily basis without incurring a cost (unless they are in a share class that has a back-end load or the sale falls within a time frame spelled out by the fund company and a redemption fee is assessed), which further adds to their appeal--that is, until it gets out of hand.

When selling other types of investment securities, investors face some form of liquidity cost or consequence. The markets for stocks and bonds have a natural mechanism in place to deal with it; for every seller, there has to be a willing buyer at that price, or the sale can't happen at that price. Not so with mutual funds. Mutual fund owners have the right to sell back their shares on any day they please, and the fund has to buy them back at a price equal to the pro rata value of the underlying securities, or NAV. If those redemptions force the fund manager to sell securities at lower prices, the investor who redeemed doesn't bear the cost. Rather, it is spread across the entire pool of investors still in the fund. It doesn't really matter if you are the only shareholder trying to sell a fund at a good time or the hundred thousandth shareholder trying to sell at a bad time, you are both entitled to the same price: that day's closing NAV. Granting investors such easy access to their money is a big plus most of the time and usually doesn't pose much of a problem for funds, but in periods where it becomes extreme, it can create disruptions with unfair consequences.

Nobody Benefits
So, if funds and remaining fundholders are hurt by extreme redemptions, do the investors who cashed in benefit? Unlikely. Cashing in during a fear-stricken period like the one we're in now is like watching a bad horror flick where the plot is clear and predictable from the very start. Investors are notoriously bad market-timers. When we study Morningstar Investor Returns--which consider the timing of investors' purchases and sales--we've found that investors buy high and sell low to their own disadvantage. Investors followed the same pattern during the last bull and bear run. And, with the level of outflows much more severe this time around, the end result may be even more pronounced.

Aside from the fact that investors' timing of such decisions is poor, sitting on cash harbors a different kind of risk that is just as dangerous. While cash doesn't have the kind of downside that we've seen with stocks and bonds lately, there's a huge opportunity cost to having too much of it. Cash has no chance of outpacing inflation and taxes, so investors will surely see their purchasing power shrivel up over time. And, by holding cash with the intent of reinvesting down the road, investors face the tough decision of when to get back in, which is close to impossible to time with any precision.

On top of that, we're hearing from a lot of talented money managers that investment opportunities are plentiful. From Warren Buffett to a normally bearish Jeremy Grantham to Marty Whitman (and the list goes on), a lot of smart investors are being very vocal about the juicy deals in the markets right now. We think investors are better off on the same side of the trade as those smart and proven investors than on the opposite side.

So, if investors who have proved to be poor market-timers in the past are again selling into a slump and their actions are limiting the flexibility of mutual funds, who wins? Nobody. We think you're better off sticking with your plan (even though it's taking you on an unexpectedly painful ride) and your funds. And, if you have money to put to work or can increase your contribution to retirement accounts, we even think it's worth going against the grain and investing it.

*Edelen, Roger M., Richard B. Evans, and Gregory B. Kadlec, Scale Effects in Mutual Fund Performance: The Role of Trading Costs (March 17, 2007).

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Karen Dolan, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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