Can Outside Help Smooth Fund Flows?

Can an outside source help mutual fund portfolio managers manage cash inflows and outflows better than they can do it themselves internally? Roger Edelen, PhD, managing director of research at San Francisco-based ReFlow, and former associate professor of finance at the Wharton School of the University of Pennsylvania, is betting so. He says fund flows negatively impact a fund's alpha, and that they have the effect of "shareholders doing the portfolio management."

Edelen says that "40% of all trades are linked to the liquidity motive," that is, trades made in response to flows. He argues that fund inflows and outflows not only make fund managers have to buy and sell at what may be inopportune times, but that the transaction costs add up, and are a drag on returns of 100 to 150 basis points annually.

But what's the alternative? Edelen suggests allowing a third-party firm to become a benevolent shareholder, buying shares from the fund at times of net redemptions and selling them back to the fund when assets flow in, smoothing flows and thereby helping to eliminate the drag on returns from flow operations.