Mutual Funds: Why the Cup Is Flowing Over

Asset flows can significantly affect performance.

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One of the many ironies of mutual fund investing is that by the time analysts pinpoint a trend, it's often too late for investors to capitalize on it. Even so, some trends are as easy to detect as they are long lasting. Flow patterns—which quantify how investors move into and out of funds—are among them. For the past 37 weeks, mutual funds have had net inflows, and this movement appears very unlikely to let up soon.

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In a paper published last month, ReFlow Management, a group that helps fund managers respond to asset flows, explored the changing dynamics of fund purchases. According to the paper, when assets under management either increase or decrease, fund managers tend to make flow-driven trades that weigh down performance. Examples include selling securities to meet redemptions (outflows) or investing at inopportune times to avoid large cash positions in the aftermath of inflows. As evidence that this harms investors, the paper cites studies indicating that when managers make strategy-driven trades, each dollar they trade pushes up the value of the portfolio by 71 cents; each dollar traded for flow-driven reasons, meanwhile, decreases returns by 86 cents.

While the shifting landscape encapsulated by the 37-week buying streak has roots in the market's recovery from its March lows, observable changes in fund flows predate the recession. "Contrary to perception, rising asset flows do not appear to be a temporary or cyclical phenomenon. Monthly flows began rising in 2006, well before the market meltdown in 2008," according to the paper.

Although recent news has focused on mutual fund net inflows, flows have cut both ways over the past few years. Notably, the recent net inflows have largely been into bond and balanced funds (those that include a mix of stocks, bonds, and cash) and have masked periodic net outflows from stock funds. This pattern points to a new era of growing market volatility, one that ReFlow says is driven by a fresh model for mutual fund purchasing.

In particular, ReFlow notes that investors are increasingly entrusting their assets to retirement plans, independent advisers, and other intermediaries rather than purchasing funds directly. This concentration of wealth into the hands of relatively few people means that when these intermediaries trade, they often move around enough money to create disruptive flows.

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Over time, ReFlow expects the situation to deteriorate. "When these dots are connected, it appears that the volatility of asset flows is not only a fundamental problem for the mutual fund industry, but it is also likely to worsen in the years ahead," according to the paper. To get a sense of the implications of this prediction, U.S. News spoke with ReFlow President Paul Schaeffer. Excerpts:

Your paper points out that the buy-and-hold mentality that once governed fund purchases is losing traction. What's behind this change in investor behavior?

I think what's happening is that there's been this whole proliferation of investment strategies, so people have more choices. And also, more and more individuals are getting advice, and I think there's more and more a focus on asset allocation and the need to adjust asset allocation given not only market conditions but also where people are in their saving and investing cycle.

How has the recession impacted flows?

I think obviously in the downturn, a lot of people and a lot of organizations changed their asset allocation. And I think we've seen that [in] a move towards the less risky end of the curve—and we're still seeing that. If you look at fund flows, the majority of fund flows are still going into the [more] risk-averse end of the curve. Mutual fund flows year-to-date have been positive, but it's mainly been in the bond and balanced area. Actually, equity fund flows have been fairly even or negative.

Outflows can be dangerous for obvious reasons. Apart from funds getting bloated, how can inflows be problematic?

[They can] force people to be buying securities or be buying in the market on days when maybe they don't want to be doing that. [Or they can get] less-than-best execution by having to put a huge inflow to work immediately. The question is, if all of the sudden you've got a $100 million allocation because you're on a couple of wealth management platforms, what's the best and most prudent way to put that to work?

Are these flows merely observable patterns, or is there a way to adapt to them?

I think the solution is for managers of mutual funds to recognize that they're in this environment where the flows are . . . not going to be as fragmented; they're going to be more dynamic.

What do you mean by dynamic as opposed to fragmented?

By that I mean that [flows] could be lumpier. [Managers are] going to have periods where they have big inflows, or they can be in periods where they have big outflows. . . . So I think what we're saying is beyond it being an important trend, portfolio managers really need to think about the techniques they're using to manage those flows and ensure that they don't impact performance, increase costs of the fund, distract from their investment strategy, or generate unwanted capital gains.

In the paper, you refer to the impacts of flow-driven trades as "hidden" costs. Why is that?

Because they're sort of embedded in the return of the fund. They're not really disclosed as part of the expense ratio. Market impact, trading costs, a cash drag on performance—they're not easily captured in the expense ratio and in the prospectus.