mutual fund redemptions on record pace

Investors have been selling their mutual funds in record numbers. According to Morningstar's Market Intelligence data, a net amount of $49 billion left mutual funds in September alone. We've been tracking redemption data since January 2000, and that's the largest one-month outflow that we've seen to date. Yet, it looks like October is on pace to beat it.

The heavy redemption activity that we've seen has implications for funds and shows a repeat of investor behavior that seems unlikely to pay off for anybody.

Many funds are carrying a small amount of cash and, at the same time, facing large shareholder redemptions. The average domestic equity fund held just less than 5% in cash as of its most recently disclosed portfolio. That means that they have little dry powder sitting around on the sidelines with which to buy depressed securities and meet redemptions.

Even if opportunities are plentiful (which many well-respected fund managers and industry pundits argue is the case), a fund facing redemptions is restricted in its flexibility to do much about it. If you're a mutual fund manager in this position, you have to sell more than you can buy, which is far from ideal when you're finding a lot more to buy than to sell.

At its worst case, depending on the liquidity of holdings in the portfolio, redemptions can trigger a vicious cycle that can really drive down a fund's value. We've seen that risk turn ugly during the past year with ultrashort bond funds such as Schwab YieldPlus and Fidelity Ultra Short Bond. The funds experienced some losses early on, which triggered redemptions that forced them to sell securities into an illiquid market, which locked in further losses, which invited more redemptions, so on and so forth. Such drastic illiquidity has been more of an issue with bonds (excluding Treasuries) than with stocks.

So, if funds and remaining fundholders are hurt by extreme redemptions, do the investors who cashed in benefit? Unlikely. Cashing in during a fear-stricken period like the one we're in now is like watching a bad horror flick where the plot is clear and predictable from the very start. Investors are notoriously bad market-timers. When we study Morningstar Investor Returns--which consider the timing of investors' purchases and sales--we've found that investors buy high and sell low to their own disadvantage.

So, if investors who have proved to be poor market-timers in the past are again selling into a slump and their actions are limiting the flexibility of mutual funds, who wins? Nobody.