Recently finance professor Itay Goldstein[Wharton], Qi Chen [Duke University's Fuqua School of Business], and Wei Jiang [Graduate School of Business at Columbia University] autored a study on the impact of large outflows from mutual funds and how the underlying investors are impacted.
The authors believe that there are four underlying factors that will determine if mutual fund investors will sell out of a fund:
the past performance of the fund; the investors’ propensity to do what they expect other investors to do, a factor called “payoff complementarities”; the fund’s liquidity; and whether the fund’s investors are primarily individuals and other small stakeholders, or banks and other large institutional investors.
The “herd mentality”:
What typically happens with investors on both the upside (Tech bubble buying) or downside…when some starts looking for the door, other will follow.
“Consequently, the payoff complementarities, or expectation that other investors will withdraw their money, increases the incentive for each individual investor to do the same thing,” adds Goldstein. “Thus the magnitude of the damage due to expected investors’ withdrawals is significant enough to alter the behavior of a sizable group of investors and cause them to redeem early.”
The followup effect of investors bailing from a fund is added cost to the current shareholders. Perhaps some of them know this is going to happen and its why they are getting out, but I’m not convinced that most investors think about this.
He says existing studies indicate that on average, so-called “forced trading” reduces a fund’s return by 2.2%. “Obviously, for illiquid assets, forced trading is likely to cause more damage. Moreover, for unusually large redemptions, the proportion of redemptions that leads to forced trading is also likely to be larger” than those current studies estimate.
And it should come as no suprise that retail investor have a quicker trigger when it comes to sales than do the institutional investors.
They also found however, that the performance-outflow relationship remained strong for funds that are primarily held by small or retail investors, but were not so strong for funds primarily held by large or institutional investors, including banks, insurance companies, corporations and such nonprofit organizations as state and local governments. The researchers say this is because institutional investors know they control large shares of the fund assets, and are therefore less concerned about the behavior of others