Funds' Big Test: The Great Redemption Rush

As redemptions swell, some mutual funds are turning to new sources of liquidity in order to avoid forced selling that shrinks fund returns

By David Bogoslaw

The battering that U.S. stock indexes have taken since the financial crisis escalated in late September has largely been the result of forced selling by mutual and hedge funds in need of cash to meet rising redemptions as fund holders head for the exits. And as the crisis drags on into late November, investors' attempts to square their accounts before yearend is exacerbating fund withdrawals. While most funds typically keep at least 3% to 6% of their portfolio's holdings in cash, the relentless selling pressure has ignited a vicious cycle that makes fund outflows even larger than normal.

TrimTabs Investment Research estimates that all U.S. equity mutual funds posted an outflow of $19.5 billion in the week ended Nov. 19, vs. an outflow of $31.8 billion the prior week. Equity mutual funds are on course to suffer outflows of up to $70 billion for all of November, after losing $68 billion in October. Last year, equity funds recorded a net inflow of $11.3 billion in October, and $9.94 billion in net outflows in November.

TrimTabs' analysis of redemptions as a percentage of total mutual fund assets is even more unnerving. That percentage was 3.3% year-to-date as of Nov. 17, vs. a peak level of 4.3% in the last bear market in 2002-2003, says Conrad Gann, chief operating officer at TrimTabs. "If redemptions were to go up to where they were [in 2002-2003], that alone would lead to another $38 billion leaving the market" via redemptions, he says.

Fire-Sale Prices

To meet redemptions, which are particularly onerous in a bear market such as the one that began 15 months ago, fund managers must either have ample cash on hand or be forced to sell holdings, often at fire-sale prices, depending on how grim the news about the financial crisis or the broader economy on any given day. Portfolio managers have been seeing more and more of those "given days" since Lehman Brothers Holdings declared bankruptcy in September.

"Daily inflows and outflows can run up your trading costs and soak up your time," says Russ Kinnell, director of mutual fund research at Morningstar (MORN) in Chicago. Now that fund managers are seeing steady redemptions, they have to manage their portfolios differently, he adds. A manager who was used to seeing net cash inflows could use that cash or sell an underperforming stock if he wanted to buy a new stock. Now that new inflows have broadly dried up, the manager may have to sell two stocks just to buy a new one, Kinnell adds.

In order to avoid forced selling, some fund families have turned to ReFlow Management, a San Francisco company that provides liquidity and tools to enhance performance to mutual funds. ReFlow provides a pool of equity capital to client funds whenever they have net redemptions. The company charges a fee —usually 0.15% to 0.17% of a fund's cash request— that is decided in a daily Dutch auction. In exchange for the cash, ReFlow "buys" shares in the fund, which the fund redeems after 28 days, either with net inflows from new investors or in-kind with actual securities that ReFlow can the sell on the open market.

Some Breathing Room

Confronting these pressures, fund managers are looking at every possible avenue to generate performance and will be paying closer attention to the impact of shareholder flows on their ability to generate returns, says Paul Schaeffer, president of ReFlow. "This environment is going to be much tougher, and people are going to look for every edge they can get," he says.