How can I know that my mutual fund is liquid enough to handle huge redemptions?

QUESTION: How can you ensure that a portfolio's liquidity is managed well so that the portfolio manager can deal with a problem of huge redemptions?

— David Young


ANSWER: Worried that your fellow shareholders are going to make a race for the exit? Given the sour returns many mutual funds are posting these days (sorry, Jacob Internet fund (JAMFX) investors), we understand your fears. If everybody in your fund suddenly wants to get out, how will it raise the cash to pay them off? Fact is, even massive redemptions aren't likely to affect the ability of most funds to pay you should you want to flee. But they could very well generate a nasty tax hit for the shareholders who stay put.

Fund managers have plenty of tools to cope with redemptions: They can funnel cash from new investors back to redeeming shareholders, draw from a fund's cash holdings, sell securities to raise the money or even borrow the money. And as dire as things may seem in Fundland these days, you can take heart that investors have historically always gotten what was due them, says Chris Wloszczyna, a spokesman for the mutual-fund trade group Investment Company Institute. "Basically the worst that might happen is there might be a brief delay before your funds become available," adds John M. Baker, a securities lawyer with Stradley Ronon Stevens & Young. "And even that is quite unusual."

Even so, redemptions can disrupt your portfolio, particularly if your funds are held in taxable accounts. A manager faced with unexpectedly large redemptions may have no good alternative to selling off sharply appreciated assets. As a result, a fund that is currently enduring poor performance can simultaneously generate large taxable capital gains, observes Baker. "The investor's concern is that there are going to be significant capital-gains distributions or the fund manager is not managing for growth but is managing for a flow of redemptions," says Anthony Ogorek, a financial planner with Ogorek Capital Management.

Generally, you want to seek out funds whose assets are growing, since a steady stream of new investments should help protect a fund manager from selling stocks he wouldn't otherwise. This prevents both a potential capital-gains distribution and keeps the fund invested in stock the manager wants to hold. Ogorek suggests looking back over the past three years and noting whether a fund has grown or shrunk. Keep in mind, these figures don't tell the whole story since changing stock prices will also affect the asset size of a fund.

You also might want to study what percentage of the fund's portfolio is allocated to cash. Naturally, cash provides some cushion to keep the manager from selling stocks to meet redemptions. Lately, the average cash level has increased a bit, with the average stock portfolio holding 5.9% of its assets in cash through the end of February, up from 4.4% in January of 2000, according to the Investment Company Institute. You can track your fund's cash holdings on its semiannual and annual statements. Even better are the more frequently updated figures found on fund Web sites or reported by fund-trackers such as Morningstar.com.

It's worth noting that so far, investors haven't fled even during bumpy markets. February was the first month mutual funds encountered net redemptions during the recent market upheaval, as investors withdrew $3.07 billion more than they deposited in stock funds, according to the Investment Company Institute. So do some homework on your fund. If the asset levels are healthy and you still believe in the manager and the fund's philosophy, you probably don't need to worry about liquidity or redemptions.