Investors Flee Active Funds

9/19/2016


More than $211 billion has poured out of actively managed U.S. stock mutual funds over the past year, partly reflecting a shift toward bonds and passive-investing strategies, including exchange-traded funds (ETFs). That $211 billion represents 2% of the total value of active stock funds.

Outflows, particularly at the extreme, are a headache for actively managed funds. To meet shareholder redemptions, managers might sell securities they would otherwise hold, potentially making unprofitable trades. Selling can generate capital gains, saddling investors with a bill and crimping after-tax performance. In some cases, persistent outflows encourage a manager to hold extra cash — a potential drag on returns. Finally, funds suffering from heavy selling might close or merge with other funds.

Research suggests that significant outflows weigh on performance, particularly for funds holding less-liquid securities, including small-cap and midcap stocks and foreign securities. One notable study, which evaluated outflows for U.S. stock funds from 1995 to 2005, estimated that "forced trading" reduced a fund's annual return by an average of 2.2%. Funds holding large stocks with significant trading volume saw smaller reductions.

Conversely, a surge of inflows can cause trouble. When investors pile into a fund, the manager might not find enough attractive buying opportunities for new cash. Typically, managers flush with cash increase positions in stocks already in a portfolio rather than adding new holdings. But SEC regulations and fund policies limit how much can be invested in a particular stock, potentially forcing managers to hold too much cash or invest in second-tier names.

A Morningstar study from 2006 to 2014 found that large-cap funds with outsized inflows averaged three-year annualized returns of 7.8%, below the 8.1% return for all large-cap funds. Small-cap funds with the biggest inflows returned 9.5%, lagging the 10.0% gain for all small-cap funds. Midcap funds gaining assets rose 9.5%,
in line with the category average.

Advice

A manager's ability to maneuver largely depends on a fund's strategy. Large money flows — in or out — can be a red flag, particularly if a fund focuses on a narrow corner of the market or invests in stocks with limited trading volume. If you own an actively managed fund facing persistent outflows, you should consider selling. With index funds, inflows and outflows are not major concerns.

OUR RECOMMENDED MUTUAL FUNDS
-- Year-To-Date --
Target Weights
Fund (Price; Ticker)
Total
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Fund
Rating
Baird Core Plus Bond ($12; BCOSX)
6.3
A
9
4
95
Dreyfus MidCap Index ($35; PESPX)
9.4
A
0
0
84
Dreyfus Small Cap Stock Index
($28; DISSX)
10.0
A
0
0
96
Fidelity Overseas ($41; FOSFX)
1.1
B
9
9
95
iShares MSCI EAFE Small-Cap ETF
($51; SCZ)
3.2
C
4
6
94
PRIMECAP Odyssey Stock ($25; POSKX)
5.9
A
7
8
92
T. Rowe Price QM U.S. Small-Cap
($27; PRDSX)
5.3
B
4
4
94
Vanguard 500 Index ($196; VFINX)
5.6
B
9
10
85
Vanguard GNMA ($11; VFIIX)
3.4
B
0
0
93
Vanguard Growth Index ($56; VIGRX)
3.9
A
10
11
91
Vanguard High-Yield Corp.
($6; VWEHX)
9.2
D
5
6
98
Vanguard Inter.-Term Tax Exempt
($14; VWITX)
3.3
C
0
0
85
Vanguard Selected Value ($27; VASVX)
4.3
E
7
10
48
Vanguard Short-Term Invest.
Grade ($11; VFSTX)
3.4
A
9
4
99
Vanguard Small Cap Value Index
($26; VISVX)
10.0
B
4
4
93
Vanguard Strategic Small-Cap
($30; VSTCX)
4.0
D
4
4
88
Vanguard Total Bond Mkt. Index
($11; VBMFX)
5.1
C
0
0
66
Vanguard Value Index ($33; VIVAX)
6.8
B
9
10
96
Vanguard Wellesley Income
($26; VWINX)
7.5
A
0
0
100
Vanguard Wellington ($39; VWELX)
6.0
A
10
10
98
* Through Sept. 13. Ranks compare funds with same objectives: A = top 20%; B = next 20%; C= middle 20%; D = next 20%; E = bottom 20%. Fund ratings are percentile ranks, with 100 the best.

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