Morningstar: Funds Flow and Liquidity Affect Performance

Two factors that can affect a fund’s performance are the level of fund inflows and the trading impact of that inflow, explains Morningstar’s Russel Kinnel in a recent article.

For most funds, writes Kinnel, “the ideal level of money coming in is a small positive inflow. It gives the managers some money to pursue new ideas with but doesn’t force them into significant selling or buying.” Kinnel points out that a large inflow can be problematic because it can be very time consuming for the fund manager and/or can incur high trading costs.

Kinnel explains that the “bloat ratio” –which indicates the liquidity of a portfolio as well as how much is needed based on past turnover— can present challenges depending on the investment strategy used. The most bloated funds, says Kinnel, suffer from underperformance. He clarifies, however, that it’s best to think of bloat and fund flows as secondary factors in fund performance. “It’s pretty rare,” he argues, “that these are the most important factors in explaining performance; rather, they are headwinds.”

For example, a small-cap momentum strategy, writes Kinnel, is particularly sensitive to heavy fund inflows “because even small amounts can drive up the prices of stocks with strong momentum.” Funds with lower turnover and more-liquid stocks, on the other hand, have greater capacity.