Funds' Big Test: The Great Redemption Rush

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The 28-day window gives portfolio managers some breathing room, allowing time for funds to attract cash inflows if stock market conditions improve after an especially rough patch that's prompted a flood of redemption requests. At the very least, the "loan"allows managers to choose relatively better days on which to sell holdings instead of being forced to sell on the day they receive a redemption request.

So far this year, ReFlow has provided $800 million in capital to funds, roughly 40% of the $2 billion it has provided since its inception in late 2003.

Some Funds Suspend Redemptions

Schaeffer estimates that daily subscriptions to Dutch auctions have doubled over the past three months, but that "fees haven't gone up because we have very good capacity," he says. Funds don't use auctions everyday and they pay a fee only when they use them.

Schaeffer says he expects to take on at least another 10 fund families, or as many as 120 funds, as clients in the last four months of 2008. ReFlow offers its service only to 1940 Securities Act funds that are in good standing with regulators. Its due diligence consists mainly of ensuring that clients understand how to use the company's services, and ReFlow doesn't deny service to any funds based on performance, such as those heavily weighted in the financial or commodities sectors.

Understandably, most of ReFlow's clients are sensitive about admitting they are using a service to provide liquidity, especially during a time when cash shortages have prompted some funds to suspend redemptions. One fund manager who was willing to talk was Rick Imperiale, who manages the Forward Progressive Real Estate Fund (FFREX), which is comprised mostly of real estate investment trusts (REIT) and real estate operating companies. While the value of his portfolio has fallen 19.4% year-to-date, Imperiale says the fund had net inflows for the first nine months of the year and only began to see "meaningful" redemptions in late October, after the fund's value dropped 26%. (ReFlow is an affiliate of Forward Management, which is the adviser to the Forward family of funds.)

Poised for Thin Trading

Last year when the REIT market was down 18%, Imperiale used ReFlow's much more frequently, while this year, despite the greater losses in the broader market, his fund has had a stronger cash position that's helped withstand the need to sell into weak markets to meet redemptions.

The real value of ReFlow becomes clear when trading volume in the stocks a fund manager holds slows to a trickle, making it hard to sell anything without running prices down dramatically, says Imperiale. "If I were under significant redemption pressure in a market like this, I'd be a much more aggressive user of ReFlow, because there are so many things that appear to have little or no liquidity if you want to sell them," he says. "I'd call that more a lack of buyers than intense selling pressure."

American Independence Funds, a boutique firm with $800 million in assets, decided a year ago "to put in some sort of redemption line in case the world did change," says John Pileggi, managing director of the New York outfit. "[That decision] really wasn't in response to any surge in redemption activity. If you're going to a put a sprinkler system in the house, it's better to do it before a fire breaks out," he says.

Smoothing Out Rough Edges

Funds like his that are marketed to investors through intermediaries such as registered financial planners or bank fiduciary officers are more shielded from the pressures of redemptions and forced selling, says Pileggi. That's because a financial adviser can "hold investors' hands" when they get anxious and can remind them about sticking to their long-term investment plans. Advisers can gently nudge jittery investors to reallocate their portfolios toward more stable asset classes, says Pileggi. Funds that sell directly to consumers are most vulnerable to investors' knee-jerk reactions to bad economic news, he adds.

While special services that boost liquidity may help smooth out the rough edges of redemptions in the short term, by making selling more orderly, they're not very effective in the longer term, when there's the risk of a vicious pattern developing where redemptions lead to depressed asset prices, which lead to further redemptions, says Gann at TrimTabs.

The Vanguard Group, whose clients invest both directly with the Philadelphia fund family and through financial advisors, has had net positive cash flows this year, according to Joe Brennan, head of portfolio review at Vanguard. He attributes that to having "one of best behaved client bases in terms of long-term thinking and not panicking," mostly the result of education and partly self-selection.

Reducing the Costs of Panic-Selling

Of course, the most basic way to boost liquidity and thereby avoid forced selling is by increasing the percentage of holdings that are held in cash, which many fund managers have been doing this year.

The smartest strategies for cash management, as you might expect, are reserved for funds that cater to high-net-worth individuals and don't deal with retail investors whose short-term need for cash tends to be far greater. In fact, Dimensional Fund Advisors decided to market its funds to investors exclusively through fee-only advisers with that precise goal in mind —to minimize costs that result from panic selling.

"By avoiding the Merrill Lynch and Fidelity investors, and by only allowing clients of fee-only advisers access, [DFA] ensured that discipline would be there when it is needed most," financial planner Andrew Orr said in an e-mail message.

But the better-heeled clients may find that discipline harder to maintain if the vicious cycle of fund redemptions and falling asset prices continues.

Bogoslaw is a reporter for BusinessWeek's Investing channel.