Effect of mutual fund sellers on remaining holders

[joesxm3]

I saw an article today that made me think about this.

It said that most mutual funds are not holding a lot of cash at the moment and although they would like to be buying stocks at these low prices they can't because of the way the cash is flowing out of the funds.

It said that unlike an individual stock where you must find a buyer in order to sell your stock, the mutual fund must redeem a share at the current NAV for anyone who wants to redeem shares. This results in the fund having to sell shares at the inopportune time to get cash to pay the redeemers.

It seems to me as if the redeemer is actually getting a benefit at the expense of the remaining mutual fund holders.

Here is my scenerio - does it make sense?

Assume that the mutual fund has 1000 shares of a stock worth $10 per share and mutual fund holders have 100 shares of the fund. The NAV is $100.

Holder A redeems 10 shares and the fund has to pay Holder A $1000. This amount is set at close of business on Monday.

If the fund does not have enough cash it needs to get some before the settlement date. That would mean it needs to sell some of its stock on Tuesday.

Assume that the price of the stock on Tuesday is $9 or that the act of the fund selling the shares drives the price down.

To get the money for Holder A the fund has to sell roughly 110 shares of the stock. That leaves the fund with 890 shares of stock.

It would seem that Holder A who redeemed, causing problems for the fund got compensated with the value of 100 shares of stock, but because the fund had to raise cash at the wrong time, the remaining Holders now have only 890 shares of stock instead of the 900 shares that they should have.

Because of this, when the price of the stock recovers the mutual fund holders will be worse off than if they had held the stock directly and had not sold any of it.

This seems to amplify the pain in a down market with panic.

I suppose if the market were going up, then the fund holders would gain from people selling since it would be the opposite of my scenario. I would think that this would happen less often.

 

[audreyh1]

I think in most cases the mutual funds know before market close that someone is redeeming and sells ahead (or on market close), and so the redeemer also bears the brunt of the reduced asset price.

Yes, does seem that mutual funds are having to deal with redemptions at this time and so are not able to put cash to work, and in fact may have built up cash during the market swoon in anticipation of redemptions, thus worsening the selloff!

We can only hope that those of us buying in at these fire sale prices will eventually reap the benefits. I suspect we will reap a tax benefit for several years as this forced selling should (hopefully) mute capital gains distributions from mutual funds for a while.

Audrey

 

[joesxm3]

Good point about the reduced capital gain distributions.

It will be nice. However, I am still working off my carry-forward losses from the dot-com bubble collapse

 

[audreyh1]

Ouch!

Audrey

 

[Gone4Good]

Yes, existing holders bear most of that loss. While Audrey correctly points out that today's NAV reflects the impact of today's sales, the cost of redemptions are socialized across the entire portfolio. That is to say the fund seller isn't given a different NAV to reflect the losses he specifically caused the fund.

This is why Vanguard tries to discourage hot money from its funds and why it imposes exit fees for short-term holders on some.

 

[freebird5825]

see document pages 26-27 here http://www.vanguard.com/pub/Pdf/index.pdf

the mass exodus from mutual funds going on in these times is astounding. it looks like the current exchange and/or redemption policies do not protect the long term holders. too bad the fund families can't offer an incentive or reward for the long term "buy-and-hold" crowd.
on the flip side, a person has the right to withdraw their investment at any time.
the cost of doing business, i guess.

i have seen some of the VG funds impose higher minimums to get into a fund that used to be an intial investment of $3K only.

 

[ERD50]

I think in most cases the mutual funds know before market close that someone is redeeming and sells ahead (or on market close), and so the redeemer also bears the brunt of the reduced asset price.

Audrey

Yes, existing holders bear most of that loss. While Audrey correctly points out that today's NAV reflects the impact of today's sales, the cost of redemptions are socialized across the entire portfolio.

Two different views above. I'll side with Audrey - I fail to see how it could be otherwise.

This is why you have to get your order in before the end of the trade. The fund company nets out the buys/sells for the day. If they were exactly equal for example, they don't have to incur any transactions. For example, $1,000 flows in from person A, and $1,000 flows OUT to person B. In that case they just move cash (one reason you have settlement delays).

But if B sells and there are no buyers that day, they sell off $1,000 at the NAV before close, and for everyone else life just goes on. Their shares were not touched. No effect.

Of course, fund selling puts pressure on the underlying stocks, just as any supply/demand shift would.

That is to say the fund seller isn't given a different NAV to reflect the losses he specifically caused the fund.

I don't understand this - the seller got his/her shares at the NAV of the day - there *is* no effect on other holders, that I can see. Other than general downward pressure in the market. But that would be the same if the seller sold individual stocks that were in the index.

Not making sense to me. Does a fund operate differently from what I described? I'd be surprised, anything else would leave them holding the bag it would seem.

This is why Vanguard tries to discourage hot money from its funds and why it imposes exit fees for short-term holders on some.

I think Vanguard is just trying to keep transaction costs low. It costs money to buy one day and sell the next. Best to charge that to the people doing the buy/sell, rather than "socializing" it across all. Not surprisingly, I LIKE Vanguard's approach!

-ERD50

 

[freebird5825]

Some historical numbers for redemptions

source: Mutual Fund Redemptions
In July 2002 mutual fund investors apparently hit their psychological limit on losses and withdrew a record $49 billion from mutual funds—significantly higher than the $30 billion they had pulled out after September 11, 2001. The July withdrawals followed $18 billion in June 2002. In August 2002 withdrawals slowed to $9 billion, but most financial experts said this level still was too high to support a sustained recovery.

source:
Investors Are Selling Their Mutual Funds at Record Speed - Morningstar Fund Spy
Investors have been selling their mutual funds in record numbers. According to Morningstar's Market Intelligence data, a net amount of $49 billion left mutual funds in September alone. We've been tracking redemption data since January 2000, and that's the largest one-month outflow that we've seen to date. Yet, it looks like October is on pace to beat it. Looking at the first half of this month and only the portion of the mutual fund universe that has reported asset figures to us, we believe a more severe outflow picture is brewing for October.

i couldn't find any running October numbers. we probably have to wait til the end of the month for data to be published.

 

[deserat]

Hmm - I haven't sold anything and have been buying instead - the DCA route. To me, the market is for buying and holding.....especially mutual funds. Perhaps I'm daft. I thought one had an asset allocation and kept to that - and adjusted it as one aged or didn't (remember the articles about retirees still needing 80% in equities just last year?)

As for the mechanism on how the mutual fund must regurgitate money for selling shareholdes - thanks for the info - didn't realize that and that it might affect the mutual fund from being able to buy low right now....

 

[freebird5825]

Hmm - I haven't sold anything and have been buying instead - the DCA route. To me, the market is for buying and holding.....especially mutual funds. Perhaps I'm daft. I thought one had an asset allocation and kept to that - and adjusted it as one aged or didn't (remember the articles about retirees still needing 80% in equities just last year?)

you're not daft. you're smart.