Newfound Rush to Redeem Means Risks for Investors Left in the Fund

Among health insurers, it’s called a “death spiral.” The mutual fund industry doesn’t have a word for it. Yet.

“It” refers to the chain of events set off when, within a group of individuals whose fortunes are intertwined, a large segment ups and leaves.

In an HMO, for instance, when the young and healthy leave, they leave behind a disproportionately sick group of people who must then pay more for their coverage. Eventually, as premiums rise, even more flee. Only the sickest remain--because they have to--and the structure collapses.

In an open-end mutual fund, it’s not as dramatic. At least it hasn’t been so far. But something similar goes on.

As a fund shows signs of weakness, an initial group of investors cashes out. Because the fund is “fully invested,” meaning it puts virtually all of its money in stocks, it must sell some of its investments to pay back those shareholders who want to redeem.

The redeemers walk away that day. Those who stick with the fund get stuck with the bill for the brokerage commissions and taxes generated by the forced sales. They’re also left with a fund of lesser value since winning investments have been sold off and cash that would have been used to buy additional stocks is expended.

“Heavy redemptions in short periods of time can hurt the portfolio manager, depending on two things: how much cash he has in his fund and what kind of stocks he owns,” said Stan Egener, president of Neuberger & Berman Management in New York.

The less cash, the worse off the fund is. The smaller or less liquid its stocks, again the worse off it is.

Egener said Neuberger & Berman has recently studied the effects of short-term trading on fund performance and determined that in general it can reduce a fund’s annual returns by 1 or 2 percentage points.

As the portfolio’s performance worsens, more shareholders redeem. And without any injection of new money into the fund, it eventually collapses.

Sound far-fetched?

Well, Robertson Stephens Developing Countries Fund recently fell victim to such a chain of events, albeit an accelerated version given the turmoil in emerging-market investing. The fund is expected to liquidate at the end of this month. It joins a growing list--nearly 100 by one count--of open-end mutual funds that have called it quits this year.

Until this year, neither the fund industry nor investors have had to worry much about redemptions.

After all, while redemptions have been steadily rising during the last 25 years, so too has the flow of new cash into these funds. The inflow made the outflow irrelevant.

But things have changed. In August, amid turmoil in world stock markets, investors redeemed $52 billion from their funds, up 10% from July. But new purchases fell by nearly 25%. The result: Fund managers saw a net $11.2 billion flow out of their portfolios.

Some portfolios got hit harder than others. Among the funds that saw the greatest net estimated outflows within their categories in August, according to Lipper Analytical Services, were Oakmark Small Cap, Robertson Stephens MicroCap Growth, Fremont U.S. Micro-Cap, Warburg Pincus Emerging Growth, Rydex Nova, Rydex OTC, Mutual Beacon and PBHG Growth.

Notes Luke Collins, director of KPMG Peat Marwick’s investment consulting practice in Chicago: “While it’s good to look for funds falling in value, investors should be wary of funds facing huge redemptions.”

That means, like it or not, you now need to be aware of what your fellow shareholders are doing. How? You can start by periodically checking your fund’s total asset size.

This information is updated monthly in publications such as Morningstar Mutual Funds and Value Line Mutual Fund Survey. Most large public libraries subscribe to one or both. Also, many fund companies periodically update it on their Web sites. (And you can always call your fund company’s 800 number.)

Obviously, not all changes in a fund’s net assets are due to redemptions. The portfolio’s performance also affects this number. But if you see that your fund’s assets plummet, for example, from $500 million to $250 million in a short period, something other than bad performance is probably at work.

If you choose to leave a fund because it’s in a downward spiral, you will be exacerbating the problem for those you leave behind. But sometimes you have to decide: Head for the lifeboats, or do the honorable thing and go down with the ship?

Some investors don’t need to worry. For instance, those who invest in the nation’s largest funds are generally safe because redemptions would have to be astronomical to seriously affect these portfolios.

Also, these funds enjoy the lion’s share of monthly inflows from 401(k) investments, long-term holdings that will only grow in size as more Americans and employers enter these plans.

But if you’re in a modest small-cap, international or emerging-market fund, beware. As Collins put it: “You don’t want to be left holding the bag.”

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Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.