(PUB) Investing 2016

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Outflows Threaten These Funds Continued From Cover

to watch flows. Although actual flow data isn’t avail- able in many places for individual investors, back-of- the-envelope comparisons of year-to-year net assets should be sufficient to spot those funds truly under duress. Take into account returns. Compare what the assets under management are with what they should be if flows were flat and you’ll get a sense of which funds face challenges. Of course, we are tracking flows closely and adjusting Morningstar Analyst Ratings accordingly, so you can take cues from our ratings as well. There are two big immediate challenges presented by outflows and several more-subtle long-term issues. Let’s start with the immediate issues: Soaring Trading Costs Typically, it costs an equity fund something like 10 or 20 basis points to make its trades over the course of a year. That includes brokerage commissions but also the impact on the stock price. A sizable fund might not have any impact with small trades, but, if it wanted to trade, say, a 4% position, it would likely drive up the price on purchase and drive it down on the sale. So, there’s a significant cost to doing such trades. There are quite a few variables at work in these issues, but the key ones are: How liquid are the fund’s holdings, how big is the fund, and how much does the manager need to trade? These are the factors embraced by the bloat ratio, but you can get a handle on these pretty easily. Smaller caps are less liquid and large caps are more liquid. High-yield bonds and bank loans are less liquid and high-quality bonds are more liquid. ( PIMCO Total Return’s enor- mous redemptions had little impact if any because it had lots of cash, near cash, and easily tradable derivatives.) In extreme cases, we’ve seen a vicious cycle in which flows hurt performance, and that spurs more outflows. Big Portfolio Shifts One way to manage redemptions is to sell off the really liquid stuff to start, which results in lower trading costs to begin with. Of course, it means the portfolio’s nature has been changed, and a second

wave of redemptions, if it occurred, could have disas- trous effects because the fund would have to sell less-liquid holdings. At PIMCO Total Return, we kept a close eye on cash and near-cash debt. We saw that PIMCO was continuing to sell from across its port- folio in order to avoid altering the portfolio mix or painting itself into a corner. On the other hand, Bruce Berkowitz mainly used cash to meet redemptions rather than sell off huge positions in AIG AIG or Sears SHLD . Flows didn’t get to the point where they caused Fairholme FAIRX to suffer big trading costs, but the cash drawdown significantly increased risk in the portfolio. The really big trading-cost hit is rare, but we’ve seen it in funds that invest in rather illiquid bonds that suddenly no one wants. Third Avenue Focused Credit TFCIX is a more recent example, with very low- quality energy bonds, and we saw a couple of high- risk mortgage funds melt down in 2008 as well. Secondary Issues Some less dramatic issues include taxes and fees. Your tax bill can rise substantially because a fund manager has to sell to meet redemptions, thus realizing gains, but then those gains are distributed to a smaller shareholder base. In a prolonged sell-off, a fund will likely have losses to offset gains, but that isn’t the case today for most domestic- equity funds, as they are up significantly during the past several years, even though they have struggled in 2016 . Smaller assets under management can mean higher fees, because many funds have management-fee breakpoints that lower expenses as assets rise. Unfor- tunately, these work in reverse, too, so watch out. If a fund’s prospectus net expense ratio was printed more recently than the annual expense ratio, it may offer a clue as to whether fees are rising. Management shakeups are another knock-on effect. Even if you decide to stick it out, the fund company may feel compelled by redemptions to take action. Sometimes those changes are clearly an improvement, but more often you are getting a less experienced manager. We saw this at Columbia Acorn ACRNX ,