Mutual funds are an attractive investment vehicle for retail investors, but those investors’ whims can pose a threat to RIAs’ clients, according to a white paper issued last week by Gurtin Fixed Income Management.
The paper said many RIAs use retail mutual funds on behalf of their clients, apparently unaware of hidden risks in these vehicles.
The risks are threefold.
Buy-and-hold investors in these funds are at the mercy of their non-professional co-investors who tend to chase past performance, buying high and selling low. This forces fund managers to time their trades poorly.
When flows are positive, managers must scramble to buy securities in order to put new cash to work, and when flows are negative, they are forced to sell securities to provide liquidity to exiting investors.
This means the manager’s decision of when to buy or sell securities, and at what price, is the result of a combination of managerial judgment and the whims of retail investors.
An individual investor’s investment performance is directly affected by the decisions of co-investors. Even buy-and-hold investors cannot escape their fellow investors’ timing decisions.
How ill-informed are many retail investors? The paper cited a study showing that 39% of surveyed investors did not know whether they were invested in no-load funds, 75% could not say what their fund’s investment style was and 72% could not identify their fund as domestic or international.
On an individual level, poor market timing can cost retail mutual fund investors big time. In 2014, the S&P 500 index returned 13.69%, but the average equity fund investor took home just 5.5%, according to an annual study by Dalbar, a financial services consulting firm.
The Gurtin paper said research had documented retail investors’ poor market timing in both fixed income and equity mutual funds, and in both passively and actively managed ones.
The best estimates, it said, suggested poor market timing reduced equity fund returns by one to one-and-a-half percentage points annually.
“Incredibly, research suggests that poor market timing driven by retail mutual fund flows lowers mutual fund Sharpe ratios by 17% and accounts for approximately 70% of the total underperformance of mutual funds relative to passive benchmarks.”
The paper said that under extreme outflow pressure, fund managers are forced to sell at whatever prices they can find in the market.
Because they typically try to sell their most liquid securities to avoid booking immediate losses, investors who hang on to their shares through a fire sale tend to be left holding shares of increasingly risky and illiquid securities. According to the paper, RIAs should be aware of the extent to which municipal bond mutual funds are more exposed to retail fund flows than other mutual funds. For one thing, municipal bond funds are disproportionately held by retail investors since most institutions do not reap the tax benefits.
Moreover, these retail investors are more risk averse and are less likely to hold shares when periods of subpar performance inevitably occur. The paper pointed to one study that found municipal bond funds were the single most performance-sensitive class.
Finally, illiquid underlying assets amplify the costs incurred when co-investors hit the exits as liquidating securities may require big markdowns.
“Mutual fund investors would benefit from separately managed accounts and mutual funds accessible exclusively through RIAs, which protect investments from retail fund flows,” said Bill Gurtin, chief executive and chief investment officer at Gurtin Fixed Income, an RIA with $9.9 billion in assets.
“These alternatives offer protection through access to professional management without compromising managerial discretion to accommodate fund flows, as well as through carefully chosen co-investors whose investment behaviors more closely mirror patient institutional capital.”
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