Ask a fund manager in public or on the record if inflows or outflows are affecting his ability to effectively execute his process and the answer is almost always no.
Heavy inflows and outflows are not definitive sell signals
Privately, however, many fund managers often admit cash flows can be a pain, particularly at the extremes. A gush of inflows can force you to hold too much cash or compromise your security-selection standards to put money to work; persistent heavy outflows can make a manager sell holdings he otherwise would hold and can wear on investment-team morale.
Recently, a seasoned fund manager conceded to Morningstar analysts that heavy inflows or outflows have a negative impact on investment strategy implementation and performance.
The optimal scenario is a little bit of money going out to meet redemptions and a little more coming in as new investments. Such a balance of inflows and outflows helps tax efficiency, he said, and imposes a discipline on managers, forcing them to regularly think about how to raise or deploy cash while ensuring the portfolio is optimally positioned for the strategy.
Putting It to the Test
We tried to gauge the effect of extreme outflows and inflows on subsequent equity fund performance. We focused on actively managed equity funds in the broad large-, mid-, and small-cap US equity asset classes and in the other global equity large- and non-US small/mid-cap stock fund groups.
We divided the funds into deciles by their net cash flow, or organic growth rates, at the start of a six-year period from 2006 to 2011, with the first decile representing the heaviest outflows or smallest inflows and the 10th decile including the funds getting the most inflows.
Then we looked at subsequent three-year absolute performance, Morningstar Ratings, and success ratios, or the percentage of funds that lived to see the end of the period and outperformed their respective Morningstar Category averages.
While not definitive, the results were interesting. US large-, mid-, and small-cap equity funds and global large-cap asset groups saw lower success ratios at both ends of the spectrum, though more so among funds getting big outflows. The global small-cap equity funds showed no real pattern.
Among large-, mid-, and small-cap and ex-US large-cap stock funds that were seeing the most outflows, just 20% to 26% of them survived and outperformed their respective category peers in the subsequent three-year periods.
Funds in the highest decile – those getting the most inflows – were more likely than those in the big outflow groups to survive. That's not surprising – what fund company would merge or liquidate a fund gathering fee-generating assets?
However, the big inflow funds' subsequent average performance looked a little worse. Between 36% and 40% of large-, mid-, and small-cap US equity funds in the best decile for flows managed to survive and outperform their respective category peers in the subsequent three-year periods, but their average returns and star ratings were usually lower than those of the typical funds in the bottom decile for flows. They also were lower than the mean of their broad asset classes.
Large-cap funds with the biggest inflows, for example, averaged 7.8% annualised and earned an average of 2.8 stars in the following three-year periods compared with 8.1% and 3 stars for counterparts that saw the most outflows; the average large-cap fund with the most inflows also lagged the 8.1% average large-cap fund gain over all the periods.
Mid-cap asset attractors gained 9.5%, which was about average for all mid-cap funds but a percentage point less than the 10.5% gained by the average mid-cap fund in the worst decile for outflows. Mid-cap funds with the highest inflows earned 2.8 stars in the following time periods compared with about 3 stars for the most-redeemed mid-cap funds and the asset-class average.
The biggest small-cap flow getters averaged 9.5% and 2.8 stars compared with 10.0% and 2.9 for all mid-cap funds and those seeing the most outflows. Interestingly, in most groups, the subsequent three-year performance of funds that survived heavy outflows was not that bad.
This may indicate that heavy outflows are a better predictor of which funds are going to get merged away or liquidated than of subsequent underperformance. Thus, the deaths of scores of poorer-performing funds make the subsequent performance of their highly redeemed fund cohorts look better.
The study offers a bit more evidence that extreme inflows or outflows can affect your fund's future. Big outflows jeopardize the viability of funds; impatient fund families may pull the plug on lagging strategies that are suffering heavy redemptions rather than wait for rebounds. Large inflows, while not hurting funds' odds of survival, can presage more-mediocre future performance. While heavy inflows and outflows are not definitive sell signals, they should be a sign to pay closer attention.
