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Helping Mutual Funds Find Liquidity Fast

Redemptions. Mutual fund companies experience them all the time. Typically, every day.

It's what makes exchange-traded funds so attractive-they are pretty liquid pools of assets which investors can buy or sell shares of rapidly and at little if any cost. To the investor that is.

That's not so for mutual funds. When a mutual fund experiences net redemptions, portfolio managers need to pay the exiting shareholders the following day. To meet redemptions, portfolio managers have a few options: use cash held in the portfolio, borrow money from the bank through a line of credit, or sell securities.

When underlying securities in a mutual fund are sold, shareholders bear the costs of the selling. The greater the value of the redemptions, the greater the potential cost to the remaining shareholders. That is because when the securities are sold there is the potential for the fund to distribute capital gains to shareholders regardless of whether or not the fund itself posts a profit or loss on the year.

In the week ended July 27, the outflow came to about $10.1 million for domestic and foreign equity funds compared to $6.84 billion the previous week, according to the Investment Company Institute. Bond funds had estimated outflows of $214 million compared to estimated inflows of $105 million the previous week. Then came the Aug. 5 downgrade of U.S. government debt by Standard & Poor's.

So what's a mutual fund to do to keep down costs with redemptions?

A technology firm which also offers financial services to the mutual fund industry claims it has figured out a way to reduce those costs. "Our goal is to make an alternative source of capital available to mutual funds to allow them to satisfy their daily redemption requests," said William White, president of ReFlow, based in San Francisco.

ReFlow gives mutual funds quick cash when shareholders bail out. In return, ReFlow becomes an investor in the mutual fund. Mutual funds can cover redemptions, using ReFlow's capital. This allows funds to avoid borrowing from a bank or selling off assets, paying commissions and potentially distributing capital gains which erode investment returns.

ReFlow does not accept money market funds as clients and received a no-action letter from the Securities and Exchange Commission in 2002 to allow to provide its service to mutual funds registered under the Investment Company Act of 1940.

Backing ReFlow is Gordon P. Getty, the son of oil tycoon J. Paul Getty, who owns a 50% stake, and Cabezon Investment Group, which owns the other 50%. Getty is also the majority investor in a private investment fund which provides the cash to the mutual funds.

Here is how ReFLow works: ReFLow will provide the mutual fund the amount of cash it needs to meet its redemption requirements concurrent with the settlement of shareholder outflows. ReFlow will redeem its position in the fund when the fund starts to have a net inflow of capital-aka more investors are buying shares than redeeming them. ReFlow, which will hold its position in the mutual fund for 28 days at most.

How does ReFlow make money? It conducts a daily Dutch auction over its website in which it auctions the injected capital. ReFlow will announce the terms of that day's auction including how much money it has available, the fee that participating funds may bid and the lowest rate that ReFlow will accept from any fund participating in the auction. The rate will typically come to at least 15 basis points of the purchase amount-aka the amount of the liquidity provided-said White.

That 15 basis points is a flat fee for 28 days at most. That means that if ReFlow gave the mutual fund company $1 million the fund company would pay $1,500.

Because mutual funds set the thresholds of their participation in the ReFlow auction, even if the fund is experiencing outflows, they may not necessarily bid for ReFlow's capital unless a specific trigger is achieved on the value of the redemption. ReFlow knows the threshold because its platform is linked to either the internal shareholder recordkeeping system of the mutual fund or its transfer agent.

White could not provide an average cost savings to a mutual fund in using ReFlow but said that the 15 basis points or the final number of basis points is supposed to be less than what the mutual fund would pay in trading costs or borrowing costs. ReFlow makes money on the fee for its liquidity service and the return on the shares it buys.

ReFlow's redemption coverage business is still small. Launched in 2004, ReFlow has 20 mutual fund families as clients. The firm shut down its Luxembourg office which served only one mutual fund complex last year.