Changing Mutual Fund Distribution Patterns Point to More Volatile Asset Flows in Future, Finds ReFlow Analysis.

Rising flows undercut fund performance, whitepaper warns

SAN FRANCISCO -- The rollercoaster pattern of redemptions and subscriptions that mutual funds have been experiencing is not due solely to the market's upheaval over the past 14 months, but also reflects longer-term shifts in fund distribution and ownership, concludes a new whitepaper by ReFlow. "In short, flow volatility is an ongoing trend that may not reverse even as the market recovers and net flows generally turn positive," said Paul Schaeffer, president of ReFlow. This finding is significant as it counters the widely held belief that volatile asset flows are a temporary or cyclical phenomenon. ReFlow is a global provider of tools that help investment funds manage the impacts of shareholder flow.

With release of the whitepaper, ReFlow also announced the launch of its new thought leadership initiative, called ReThink@ReFlow. "As a specialized service provider to mutual funds, ReFlow has a unique perspective on industry trends. For that reason, we believe our research can be especially helpful to fund companies as they navigate a changing business landscape," said Schaeffer. He said the new whitepaper is the first in a series of analyses ReFlow will be offering under the "ReThink" umbrella.

While in 2008 the mutual fund industry experienced its first annual net outflow in 20 years, the volatility of monthly flows began rising in 2006, states ReFlow's whitepaper [see chart]. It also notes that in every year over the last decade, more than half of all long-term mutual funds experienced at least one quarterly net outflow.

"This is really a fund performance issue, because large outflows or inflows often lead funds to engage in trading they would never initiate otherwise," commented Schaeffer. "Not only does flow-driven trading incur significant costs without adding portfolio value, it can drive funds to market under adverse conditions, throw investment strategies off track, and create unwanted capital gains distributions."

Schaeffer cited academic studies showing that each dollar of strategy-driven trading increases portfolio value by an average of 71 cents, but each dollar of flow-driven trading lowers fund returns by an average of 86 cents. Flow-driven trades are estimated to account for 30 to 40% of all mutual fund trading, research shows.

Among reasons why asset flow volatility will continue to rise in the future, the whitepaper cites:

* A fundamental shift from direct to intermediated mutual fund investing, whether through retirement plans, financial advisers, or other third parties. According to a 2008 Investment Company Institute survey, only 13% of investors mainly buy mutual funds directly from mutual fund companies or via a discount brokerage; 51% invest mainly through an employer-sponsored retirement plan, 36% through a financial adviser.

* The move toward no-load funds, which allow investors to switch from one fund or asset class to another with no cost. Partly as a result, buy-and-hold strategies are declining in popularity and the average holding period of both equity and bond funds is dropping.

* The growth of defined-contribution retirement plans, which produce constant inflows through employee paycheck deductions, as well as account withdrawals and rollovers when employees leave or change jobs. Nearly half of all mutual fund assets are now held in retirement plans, states the report, citing Investment Company Institute data.

* The growing influence of independent, fee-only advisers who add portfolio value by shifting investors' asset allocation as market conditions change. Between 2003 and 2007, registered investment advisers quadrupled the share of mutual fund assets they control, the white paper states.

* The rise of wealth management platforms that centralize decision-making on behalf of thousands of individual investors.

* A rising tide of retirees, a majority of whom are expected to fund their retirement with regular or lump-sum withdrawals from retirement plans or other mutual fund investments. The number of Americans aged 65 and older will more than double in the next 40 years, according to U.S. Census Bureau forecasts.

The whitepaper recommends that mutual fund executives track and analyze their asset flows and related costs, examine how their distribution strategies and product mix may be affecting asset flows, and explore strategies for mitigating the performance impacts of shareholder flow. It also predicts that trading costs will increasingly be scrutinized by regulators and by intermediaries who screen and select mutual funds. Morningstar has already announced that it will release a trading-cost metric later this year.

Titled "How Mutual Fund Ownership and Distribution Are Changing--and What That Means for Fund Performance," ReFlow's whitepaper can be downloaded from http://www.reflow.com/rethink/whitepaper.pdf. To access additional ReFlow research, please visit www.reflow.com/rethink.

Founded in 2002, ReFlow serves U.S. mutual funds and European investment funds (UCITS). The firm is headquartered in San Francisco with an office in Luxembourg. Its performance-enhancing toolkit has been approved by the boards of 22 mutual fund families, representing more than $372 billion in assets, for use by 467 funds. For more information about ReFlow and its tools for managing the impacts of shareholder flow, please visit www.reflow.com.

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