Fund exodus could sting loyal investors

By Chuck Jaffe, MarketWatch

Panic selling affects investment returns, taxes

BOSTON (MarketWatch) — Watching a market that seems to be running away from everything but the safest investments, it’s hard to be a mutual fund shareholder and not worry that you’re being left holding the bag.

You’ve heard the talking heads saying that “traders” are the guys moving money around to capitalize on the news of the moment, while “investors” are sticking with their strategies for the long haul. You’ve lived through downturns before, and know that investors have a history of selling at the worst-possible times.

Still, it’s hard not to wonder how a mass exodus would affect you, and whether you should run with the herd.

If you’re lucky, any impact will be minimal, but since no one is feeling lucky about investing these days, you should at least understand what might be in store for you if you stick around while those around you are bailing out.

Faith and redemption

While the majority of stock funds have a mandate to be “fully invested,” just how much cash a fund keeps on the sidelines varies. Some funds make market calls or timing decisions where the manager keeps some or all assets on the sidelines when they can’t find anything to buy, but others try to keep as much money working as possible at all times.

There lies a big part of the concern when funds face panicky investors.

Say a fund has $100 million in assets, and invests all but $2.5 million of it. If nervous investors redeem $5 million in shares, the manager must sell something to pay those jumpers.

This is bad news for remaining shareholders in at least three ways.

First, the manager’s focus on generating returns might instead be diverted to raising cash. As a result, management strategies may be constrained; if the fund must sell securities to meet redemptions, those trades are made for reasons that have nothing to do with the value or potential of the underlying securities. Now shareholders are forcing the manager’s hand; that’s how they leave the folks who stick around holding the proverbial bag

Next, you pay the transaction costs when securities are sold to meet redemptions. Those actually come off the top; they’re not a part of the fund’s expense ratio, so you may not notice the dollars being siphoned off, but extra trading costs dampen performance.

Third, dumping those underlying holdings could create a taxable event. In the three years since the financial crisis of 2008, most mutual funds have worked off the tax-loss carryforwards that were created while they were getting hammered. The stocks they own now were purchased at discounted prices, and have since ridden up to where a sale today could lock in a gain, despite the recent market downturn.

If the fund recognizes that gain now and does not have losses to offset it by year’s end, it must distribute the gain to shareholders, who will have to pay taxes on that payout.

Given where the average fund stands today, that puts the rest of the year in an ugly light, as it’s entirely possible that investors will see their funds stay flat or lose money in 2011, but have a capital gains tax bill for their trouble. [This does not happen with exchange-traded funds because of the way those investments are structured.]

Matter of trust

And then there is the timing problem that if the fund has to sell into these pressures, it might be locking in the worst of the market, even though you were holding on for the rebound.

“If you run a small-cap equity and you had to sell [this week] into this market, you probably had your face ripped off,” said Mike Cagney, managing principal of ReFlow, a firm that works with funds to minimize the harmful effects of liquidity. “That’s a no-win spot for shareholders. They’re holding on, but the fund is forced to lock in losses, performance is suffering, and they will have to pay taxes on it anyway at the end of the year.”

How big a problem this becomes depends on money flows and strategies, which vary by fund. It will be less likely to happen in deep market categories like large-cap stocks, or in funds where shareholders stand fast together, though it’s hard to know what your friends and neighbors are doing in times like these.

Analysts at Lipper Inc. say the average fund won’t face “forced sales” until net outflows reach $75 billion industry-wide over a three-week period. Up through last week, flows were nowhere near that level; industry watchers think the final numbers from this week will be much worse, but not yet to the point where forced sales become the norm.

“Heavy redemptions at a time when a fund has a low cash position are a problem, but most fund investors won’t have any idea if it’s happening in their fund,” said Jeff Tjornehoj, senior research analyst for Lipper Inc.

“Basically,” he added, “you have to trust that your manager has positioned the portfolio in a way that anticipates what investors might do here and that minimizes the problem … and right now some investors are having a hard time trusting anything in this market.”