How Fund Flows Affect Fund Fees

ASK THE EXPERT: When large amounts of money move in and out of a fund levies are applied to the buyer or seller in order to protect existing shareholders

Emma Wall 6 August, 2015 | 3:17PM
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Emma Wall: Hello and welcome to the Morningstar series 'Ask the Expert'. I'm Emma Wall and I am joined today by Simon Dorricott, Fund Analyst at Morningstar.

Hi, Simon.

Simon Dorricott: Hi.

Wall: So, we are here today to talk about fund flows and fund fees and how the two are intertwined. This is triggered by the fact that there have been quite a lot of outflows from, a couple of M&G funds, a couple of bond funds and indeed their emerging market funds. This has affected the pricing, hasn't it?

Dorricott: Indeed, it has, yes. So, what we see with most funds is that they have a system in place, whereby they can adjust pricing dependent on the net flows into these products. The main aim of that is to protect existing investors from the transaction costs that are associated with trading and portfolios where you have an imbalance between buyers and sellers.

When that happens, the investment manager has to go into the market to buy and sell the underlying stocks and obviously that has costs that can either be borne by the fund or borne by those investors who are actually triggering the transactions.

Wall: In a closed end fund, this is where the premium and the discount come into place. But with open end funds, there are number of measures that the fund can use to as you say protect those existing investors.

Dorricott: Exactly right. So, traditionally I think the most common way of doing this, is via dilution levy. This would be levied on individual trades that were of quite a significant size. So it's unlikely to affect a retail investor, but would have an impact on institutional investors who are dealing in pretty large size. So they would have an extra fee added to the pricing that will compensate the fund for the dealing transactions that would result from their dealing in the fund itself.

This is a good measure, if imbalances in terms of net flows are due to one large investor, but obviously it doesn’t help if a fund is growing in size pretty consistently or indeed shrinking. In that situation, there are other measures that other funds have employed, other groups have employed, which will protect the existing investors. So there is a swing in pricing and also small number of groups have implemented a fixed dilution levy whereby all individual trades are subject to a small fee that reflects the potential cost of transactions in the underlying securities.

Wall: So basically, if buyers and sellers aren't matched, whoever is the one that’s tipping the scale will bear the burden cost wise.

Dorricott: Exactly and it's really a question of – as I say protecting existing investors where they are not trading in the fund. Fund groups are now very aware of the impact that trading can have on the fund performance and they don’t want their longstanding investors to be impacted by that cost.

Wall: So when you see as investor mass outflows from X fund and you are a shareholder in that fund. There is no need to panic because these things are in place?

Dorricott: Indeed yes. That’s really where the swing pricing comes into effect. On days where there are significant net flows and the manager therefore has to trade the portfolio to meet those demands. The price will be adjusted. So investors will see an impact in terms of the value of their portfolio because the price will be swung and that will be reflected in the performance profile of the portfolio. But the idea is that, that’s just reflecting or recouping some of those transaction costs for the long-term benefit of the fund performance and therefore long-term holders.

Wall: Simon, thank you very much.

Dorricott: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar

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