Intuitively, most investors understand that in an open-ended fund, managers must buy more shares when they have inflows and sell existing holdings when they have redemptions. However, it is easy to underestimate the profound effect these flows can have on fund performance. The risks in managing this have been thrown into the spotlight with the suspension of the Woodford Equity Income fund.
Managers of open-ended funds, particularly those that are contrarian in style, walk a tightrope. They may believe they have a portfolio of undiscovered gems, ripe for repricing, but if the market is slow to react and their investors start to lose heart, outflows may force them to sell out of their existing holdings.
More importantly, they may have to sell those companies for which there is a captive market. This may be their strongest ideas. Peter Toogood, chief investment officer at The Adviser Centre, says: “It is infinitely more challenging to manage a fund that is in net redemption mode. Decisions to liquidate stocks are not positive investment decisions, but rather ones based upon which stocks can be sold most readily at the best possible prices. These actions clearly have the potential to create unwanted skews and biases in a portfolio, creating style drift and disrupting a fund manager’s usual decision-making.”
It is not only redemptions that can cause a problem. Kel Nwanuforo, investment consultant at Asset Intelligence Research, says inflows can create difficulties as well: “A period of inflows would see the manager making more purchases of the fund's holdings, which could in itself push prices up - and vice versa.”
He adds: “The manager of a popular fund seeing a lot of cash come through the door may struggle to find sufficient opportunities to put it all to work. The result could be assets purchased at unfavourable valuations or, alternatively, the cash balance of the fund rising while the manager bides their time.”
History is littered with examples of funds that have grown too quickly and managers who have struggled to stick to their process as a result. This is particularly true with less liquid asset classes such as smaller companies or corporate bonds. While fund management groups often strenuously deny the link between fund size and a drop off in performance, it happens too often for it to be a coincidence.
Another problem, says Nwanuforo, is the “telegraphing” problem: “Other big investors are likely to catch on quickly if a particular manager is seeing considerable inflows or outflows, and may seek to take advantage of this.” For example, a fund experiencing ongoing withdrawals may find that other investors start to short its holdings in the knowledge that the manager will have to continue to sell. This means that the fund manager with outflows is always selling under pressure.
Beware Rapidly Changing Fund Sizes
How can investors guard against these problems? Being wary where fund size appears to change quickly in a relatively short period of time is important. High-profile funds and managers are vulnerable to popular sentiment both on the way up and on the way down.
It can also be worth asking a fund manager about the concentration of holders in the fund. In the recent Woodford case, for example, the decision to close the fund to redemptions came after the loss of a £263m mandate from the Kent County Council pension fund. Funds with a relatively concentrated unit holder base can be vulnerable to a large investor pulling their holdings.
Fund managers may have specific procedures in place but liquidity will change in different market conditions. Toogood says: “Liquidity in the main equity markets is (notionally) ever-present, selling into weak markets always comes at a cost. You can probably get your money back, but you will have paid a high price for that privilege in stressed conditions.”
Commercial property funds tend to carry high levels of liquidity – in the form of cash or property shares – to offset the impact of negative fund flows. This may act as a slight drag on performance (the returns on cash may be lower than that of commercial property) but can defer the moment when funds need to be “gated”.
Corporate bond funds may have the same challenge. Toogood says: “Investors must be aware that any fund can suspend dealing in difficult circumstances, may they be fund-specific or a function of overall market conditions.”
He says that re-checking the skews in a portfolio regularly is vitally important: “If you have assessed the characteristics of a fund correctly, you should have identified the factors that drive a manager’s success and the shape of the portfolio that allows him or her to thrive. If the portfolio begins to drift away from those characteristics and factors, you have a problem. Recent press surrounding certain high-profile funds are examples of the need to carry out constant and rigorous monitoring.”
Capping Inflows
Some companies restrict the inflows into their funds to help avoid this. JO Hambro Capital Management, for example, puts a cap on inflows into some of its funds. This, it believes, prevents the boom and bust cycle that can be seen with star fund managers and helps to moderate flows. The other answer is investment trusts, where the pool of assets is fixed and where fund managers don’t have to spend time managing inflows and outflows.
Heavy flows may present a considerable day-to-day challenge for fund managers, Nwanuforo says: “They may find that they spend an increasing amount of time on cash management as opposed to fundamental investment research.”
