100 / 708
2
to watch flows. Although actual flow data isn’t avail-
able in many places for individual investors, back-of-
the-envelope comparisons of year-to-year net assets
should be sufficient to spot those funds truly under
duress. Take into account returns. Compare what
the assets under management are with what they
should be if flows were flat and you’ll get a sense
of which funds face challenges. Of course, we are
tracking flows closely and adjusting Morningstar
Analyst Ratings accordingly, so you can take cues
from our ratings as well.
There are two big immediate challenges presented
by outflows and several more-subtle long-term issues.
Let’s start with the immediate issues:
Soaring Trading Costs
Typically, it costs an equity fund something like
10
or
20
basis points to make its trades over the course
of a year. That includes brokerage commissions but
also the impact on the stock price. A sizable fund
might not have any impact with small trades, but, if it
wanted to trade, say, a
4%
position, it would likely
drive up the price on purchase and drive it down on
the sale. So, there’s a significant cost to doing
such trades.
There are quite a few variables at work in these
issues, but the key ones are: How liquid are the fund’s
holdings, how big is the fund, and how much
does the manager need to trade? These are the factors
embraced by the bloat ratio, but you can get a
handle on these pretty easily. Smaller caps are less
liquid and large caps are more liquid. High-yield
bonds and bank loans are less liquid and high-quality
bonds are more liquid. (
PIMCO
Total Return’s enor-
mous redemptions had little impact if any because it
had lots of cash, near cash, and easily tradable
derivatives.) In extreme cases, we’ve seen a vicious
cycle in which flows hurt performance, and that
spurs more outflows.
Big Portfolio Shifts
One way to manage redemptions is to sell off the
really liquid stuff to start, which results in lower
trading costs to begin with. Of course, it means the
portfolio’s nature has been changed, and a second
wave of redemptions, if it occurred, could have disas-
trous effects because the fund would have to sell
less-liquid holdings. At
PIMCO
Total Return, we kept a
close eye on cash and near-cash debt. We saw
that
PIMCO
was continuing to sell from across its port-
folio in order to avoid altering the portfolio mix or
painting itself into a corner. On the other hand, Bruce
Berkowitz mainly used cash to meet redemptions
rather than sell off huge positions in
AIG
AIG
or
Sears
SHLD
. Flows didn’t get to the point where they
caused
Fairholme
FAIRX
to suffer big trading costs,
but the cash drawdown significantly increased risk
in the portfolio.
The really big trading-cost hit is rare, but we’ve seen
it in funds that invest in rather illiquid bonds that
suddenly no one wants.
Third Avenue Focused Credit
TFCIX
is a more recent example, with very low-
quality energy bonds, and we saw a couple of high-
risk mortgage funds melt down in
2008
as well.
Secondary Issues
Some less dramatic issues include taxes and fees.
Your tax bill can rise substantially because a fund
manager has to sell to meet redemptions, thus
realizing gains, but then those gains are distributed
to a smaller shareholder base. In a prolonged
sell-off, a fund will likely have losses to offset gains,
but that isn’t the case today for most domestic-
equity funds, as they are up significantly during the
past several years, even though they have
struggled in
2016
.
Smaller assets under management can mean higher
fees, because many funds have management-fee
breakpoints that lower expenses as assets rise. Unfor-
tunately, these work in reverse, too, so watch out.
If a fund’s prospectus net expense ratio was printed
more recently than the annual expense ratio, it may
offer a clue as to whether fees are rising.
Management shakeups are another knock-on effect.
Even if you decide to stick it out, the fund company
may feel compelled by redemptions to take action.
Sometimes those changes are clearly an improvement,
but more often you are getting a less experienced
manager. We saw this at
Columbia Acorn
ACRNX
,
Outflows Threaten These Funds
Continued From Cover