Advisors who recommend U.S. equity mutual funds should pay attention to a trend that accelerated in 2015.

After decades of gathering assets from U.S. households, domestic equity funds are melting down in size.

The trend is driven by secular factors such as investor preferences for ETFs and the retirement income needs of retiring baby boomers.

Read: Another slack year for active funds

It has repercussions for clients concerning the cost of mutual fund ownership and the liquidity of domestic equity fund portfolios.

Mutual fund net flows are defined as share sales + reinvested dividends - share redemptions.

Along with investment performance, net flows are a driver of AUM for the U.S. mutual fund industry, as well as specific funds. 2015 is just the second year of the past 27 in which all long-term U.S. mutual funds have had total net outflows, as measured by the Investment Company Institute (ICI).

While 2015’s net outflow of $72 billion was less than the $225 billion in 2008, the investment environment was far more benign in 2015. You can find historic data on mutual fund net flows here and here.

More significant are the huge recent outflows in domestic equity funds, by far the largest mutual fund category.

Domestic equity funds had record net outflows of $170 billion in 2015 (through 12/22), more than three times greater than the previous record of $48 billion in 2008.

This was the 12^th straight year in which more cash has exited domestic equity funds than has entered.

It’s still a puzzle why investors are fleeing domestic equity mutual funds, while other categories such as world equity and municipal bond mutual funds show inflows. But it’s a trend financial advisors should heed--for purposes of recommending domestic equity funds in general and choosing specific funds.

In the new era of permanent outflows, domestic equity funds are more expensive to own. When mutual funds must constantly liquidate securities to meet redemptions, they incur several types of cost including portfolio disruption, increased tax impacts, brokerage commissions and liquidity premiums.

Liquidity premiums exist because many domestic equity funds own the same securities and are forced to sell them at the same time to meet redemptions.

Meanwhile, short sellers can see what the funds hold in their portfolios and pounce on opportunities.

While it’s hard to measure liquidity premiums, researchers at the Federal Reserve’s Division of Economic Analysis have tried, and you may find their analysis interesting.

Here is one high-level conclusion: “For the average U.S. equity fund, equity portfolio liquidity decreases after a fund experiences outflows. A 10% outflow increases the impact of selling $10 million of asset weighted average equity portfolio holdings by 11 basis points.” (See this SEC white paper.)

Before recommending an equity mutual fund, advisors should know whether it is experiencing large outflows. This information can be found in the most recent annual or semi-annual report in a section called Capital Share Transactions.

Focus on the total net increase or decrease in the dollar amount of all share transactions for the most recent year.

Instant Insights /

Responding to a new era of domestic equity mutual fund outflows

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