It has become a monthly ritual to scrutinize the amount of money gushing out of actively-managed funds and into passively-managed ones.Morningstar | Here’s the latest monthly summary from Morningstar. Asset managers are rightly concerned about the persistent trend. It feels like twilight, following four glorious decades of managing other people’s money.
I’ll leave the dissection of that to others, at least for now. (I will soon be writing a white paper on critical issues for asset managers to address in today’s environment, which will be distributed via my “investment ecosystem” listThe Investment Ecosystem | Sign up on the site to receive the white paper.). Instead, this posting considers some other critical aspects of asset flows.
As the available research shows (and anyone with experience in the business knows), flows follow performance. To varying degrees, it is true in every part of the investment world. Individuals and institutional investors alike chase performance. Avoiding that tendency is behaviorally difficult but essential for long-term success.CFA Institute | Here’s a presentation that I gave to a wealth management audience on the topic.
Interestingly, those flows in turn have an effect on performance, a phenomenon that is underappreciated. An easy to understand example of that is the boom and bust of the Janus equity funds during the dot-com era.
Their strong early performance was driven by the out-sized exposure to the high fliers of that time, which led to huge increases in assets at the firm as people clamored to get on board. The portfolio managers put the cash to work in the same stocks that had been outperforming already, providing a persistent and growing bid for them, and goosing performance even more in the process.
It all worked until it didn’t, at which time the opposite dynamic occurred. The virtuous cycle turned into a vicious one, as the portfolio managers had to sell stocks every day to meet withdrawals, just as they had had to buy them to invest the inflows.
There hasn’t been a lot of research on the impact of flows on performance, a shortcoming that I hope will be addressed going forward. One study that was published in the Financial Analysts Journal, “Flows, Price Pressure, and Hedge Fund Returns,”Financial Analysts Journal | The article, authored by Katja Ahoniemi and Petri Jylhä, appeared in the September/October 2014 issue. concluded that “one-third of estimated hedge fund alphas are due to flows.” In other words, credit is being given to the managers for “skill” that isn’t really deserved.
Undoubtedly, sizable or unusual flows cause problems for investment organizations. Strong inflows can change the opportunity set for portfolio managers and lead to distortions in philosophy and process. Operational problems can also arise, and it becomes easier to fall into a “growth for growth’s sake” way of thinking that lays the foundation for long-term problems.
On the flip side, strong outflows are obviously a problem. In a business driven by assets under management, the financial effects of a fall in assets can impede the organization’s ability to compete. Also, it’s just downright depressing as a portfolio manager to have to sell securities day after day when you don’t want to do so. It colors your thinking.
Of late, it seems that there has been an increase in the volatility of flows for many investment providers. For example, a number of multi-billion dollar hedge funds have closed up shop or altered their operations significantly after large declines in assets. And Russel Kinnel of Morningstar has written about the “flowmageddon” in the mutual fund world, at individual fundsMorningstar | “A striking 18 Morningstar 500 funds suffered outflows of at least 40% of assets under management in the trailing 12 months ended February 2016, 61 shed 25% or more, and 168 had outflows of 10% or more.” and fund families.Morningstar | There are increasing numbers of fund families with notable outflows.
In writing about the unwinding at Pimco Total Return Fund, Roland Meerdter said this: “The fund had reached a state of auto-flow: the stage at which the money into an investment product decreases in terms of quality while its volume increases. A fund in auto-flow often has become the ‘default’ for a specific asset class. Once auto-flow is disrupted, the imbalance causes cascading outflows.”Propinquity | Meerdter’s piece was actually written before Gross left Pimco; the outflows accelerated significantly thereafter. Growth Fund of America and Marketfield Fund are two other great examples of that dynamic in action. (Marketfield in particular is an outstanding case study that shows the pitfalls of performance chasing and the value that can be destroyed by the industry’s marketing machines.)
The notion of auto-flow can be extended to strategies of one kind or another, as unbridled popularity leads to bloated exposures, overcrowdedness, diminished opportunities, and increased risk of pressure on performance as assets flee a strategy when it falls from grace.
Think about three types of investments in particular. Over the last decade, there have been significant increases in the percentage of assets that fall under the “alternatives” banner; the conceptual rationale for investors having done so has not yet been tested to any great degree. It’s a broad category with many different kinds of strategies, but should results underwhelm over the next few years, you could see assets moving out by rote, just as they had moved in.
Low-volatility equity strategies have been very popular, so popular that many of the stocks within them trade near historically high valuations. We’re already seeing some evidence of underperformance emerging in this area. If it continues, you could see substantial flows out.
Then there’s the big kahuna itself: passive. It’s been on an enormous roll. Certainly I don’t know when that will change (if it will change), but just imagine if active managers were able to outperform for a year or two or three. There could easily be a substantial shift in flows that would change the environment in significant ways. If a juggernaut like that unwinds, the implications are enormous.
There is a life cycle to everything in this business and it pays to think about the ramifications of the established order coming under pressure.
My bottom line: It’s time to take a more nuanced view of asset flows, the impact that they have on performance, and the way that they can distort the workings of the markets and the choices that we make.