Cash Flow Can Help or Hinder Performance

Most investors seem to realize that a mutual fund’s size can influence its performance. Truly large funds are harder to manage, while small ones tend to run up relatively high expenses.

Less obvious than size is the impact that cash flow can have on a fund. “This is something that’s often overlooked,” says Don Phillips, editor of Mutual Fund Values, a Chicago-based research publication. “But trying to manage a fund that lacks a predictable asset flow is akin to landing a plane on an aircraft carrier at sea.”

Few portfolio managers enjoy the luxury of a stable asset base. Most work under the threat that a market crash or some other event could trigger a wave of shareholder redemption orders, which would force them to sell securities. To address this redemption danger, stock fund managers now tend to hold more cash than they did before the market crash of October, 1987. The drawback of a large cash holding, of course, is that it will drag down performance during periods when stocks are rising.

Whenever a fund loses a significant amount of investor dollars--either suddenly or over many months or years--that can hurt performance if the manager must sell off promising securities.

Worse yet, smaller investors are notorious for redeeming near market bottoms. That not only forces the portfolio manager to realize losses but also strips him of money that could be used to pick up bargains. “Usually when the public is selling en masse, that’s when you want to buy,” says Roy McKay, lead portfolio manager of the Scudder Development Fund in New York.

Heavy withdrawals can be especially damaging to funds that hold relatively illiquid types of securities. The prices of thinly traded small stocks, municipal bonds or corporate junk bonds sometimes fall drastically when a big player such as a mutual fund bails out.

A manager might have to sell his highest-quality holdings first, leaving the portfolio saddled with a greater proportion of obscure, illiquid issues. Critics say many junk bond funds have had to sell off their best securities over the past two years because they can’t find buyers for the worst.

McKay, who with Scudder Development focuses on small-company stocks, says the one advantage of getting a wave of redemptions is that it may force a shrewd manager to weed out his weaker holdings. “If you don’t have to sell a stock, you might rationalize on why you should keep it,” McKay says. But he agrees that it’s generally easier to run a fund that enjoys a positive cash flow.

Some observers go further and argue that strong cash inflow can actually improve performance. Intuitively, this makes sense for several reasons. With new money coming in, the manager can bargain hunt during periods of market weakness, and he doesn’t have to worry about unloading securities to meet redemptions. Also, if the manager holds promising illiquid stocks or bonds, he can bump up the price by purchasing additional shares--the reverse of the problem plaguing junk bond funds.

There’s even the argument that a strong cash flow boosts the fund company’s profits, allowing the firm to hire better investment managers.

Sheldon Jacobs, editor of the No-Load Fund Investor newsletter in Hastings-on-Hudson, N.Y., found a correlation between cash flow and investment returns for aggressive growth funds during 1988 and 1989. Funds that enjoyed an annual cash inflow of 50% or more posted the best gains each year, while those suffering a cash outflow fared the worst.

Perhaps more telling, the most successful funds have benefited from a steady inflow of new cash over the years. Of 25 top performers over the past decade, 20 enjoyed asset growth that exceeded their investment returns (this list excludes funds that have closed their doors to new investors, thus restricting cash inflow). The most successful fund of all, Fidelity Magellan, posted a compounded total return of about 21% annually from 1981 through 1990. Yet Magellan’s assets grew at closer to a 75% annual pace over that span.

You can check the current asset size by reading the fund’s shareholder reports and prospectus. Various investment newsletters and financial magazines also include these numbers. Comprehensive research publications such as Mutual Fund Values and the Wiesenberger Investment Cos. Service, available in many libraries, show a history of asset growth or decline for each portfolio listed. Or you can simply call the fund company and ask the service representative for information on total assets.

Be sure to look at the net cash inflow or outflow--not the amount attributable to market fluctuations in the securities held. Suppose a fund’s assets during the course of a year rose to $65 million from $50 million. If the value of each share increased by 10% over that period, then $5 million of the fund’s growth can be attributed to market fluctuations. The remaining $10 million resulted from cash inflow provided by new investors or existing customers buying additional shares.

Mutual funds report their current assets on a quarterly basis, but there’s no need to track changes this closely. Rather, Jacobs recommends that you monitor a fund’s size on an annual basis. McKay suggests waiting as long as two years to sell a fund that’s suffering from poor performance and cash outflow.

In short, a persistent decline in assets is a definite red flag, while a steady cash influx makes the portfolio manager’s job easier and could point to good performance ahead. “Cash flow isn’t the most significant factor in the world,” Jacobs says. “But it does seem to make some difference.”

THE INS AND OUTS OF CASH FLOW

Some investment pros believe cash flow can affect a mutual fund’s performance. When new money pours in, a portfolio manager can keep buying securities whenever he wants. Conversely, heavy redemptions may force the manager to sell promising stocks at inopportune times. This chart examines the cash flow of the 10 best- and worst-performing funds over each of the past four years. These results exclude the impact of investment gains or losses on the funds’ asset size.

Number of 10 Best Funds: 1987 1988 1989 1990* With high cash inflow (50%+ per year) 7 7 7 6 With modest cash inflow (0%-49% per year) 1 3 1 4 With cash outflow 2 0 2 0

Number of 10 Worst Funds: 1987 1988 1989 1990* With high cash inflow 0 0 0 0 With modest cash inflow 1 2 0 1 With cash outflow 9 8 10 9

* 1990 results through third quarter