The Schwab YieldPlus Fund ( SWYPX) began to unravel in August 2007.

The fund lost 1.7% that month, a shocking development for a short-term bond portfolio that had been considered safe. The trouble started when portfolio managers tried to squeeze out more yield by investing in subprime mortgages. After seeing the losses, mutual fund investors dumped their shares.

Schwab ( SCHW) portfolio managers sold investments at discounted prices to raise cash to cover withdrawals, worsening the situation. The trickle of redemptions turned into a flood. The fund's assets fell to less than $300 million from $13.5 billion in less than in 15 months. Those investors who stayed aboard lost 42%, during the 12 months through February, according to Morningstar ( MORN).

Schwab was among many mutual funds companies forced to sell holdings in the face of mounting redemptions as the stock market collapsed. The move typically exacerbates the situation by hurting fund performance, prompting more investors to pull their money.

"During a downturn, managers are forced to sell at a time when they see lots of bargains that they want to buy," says Karen Dolan, Morningstar's director fund analysis.

In the past year, investor withdrawals have sapped more than 70% of the assets of the JPMorgan Bond ( JMIBX), Morgan Stanley Balanced ( MPBAX) and PIMCO StocksPLUS TR Short Strategy ( PSTIX) funds.

Forced selling has taken a severe toll on short-term bond portfolios, including the AMF Ultra Short ( AULTX), Metropolitan West Ultra Short Bond ( MWUSX) and Fidelity Ultra-Short Bond ( FUSFX) funds. The funds' managers sold corporate and mortgage-backed securities after their values had plunged, locking in losses they can never recover.

Some managers take the opposite approach and sell winners at a profit, creating tax bills for shareholders. The capital gains taxes can be particularly painful during downturns.

Suppose a fund sells only winners last year and booked capital gains of $1 per share. At the same time, the fund share price dropped from $10 to $9 because the value of some stocks in the portfolio declined. At tax time, shareholders will be required to pay capital gains taxes, even though their fund declined 10%. That was the experience of investors of the Janus Aspen Mid Cap Growth Fund ( JAAGX), which lost 43.7% in 2008 but distributed capital gains of $1.93 per share.

Along with tax bills, funds hit by redemptions might suffer from higher trading expenses. Besides brokerage commissions, expenses can include what's called "price impact." As a fund sells stocks, it depresses prices, increasing the cost of each trade.

Transaction costs normally can exceed 0.75% of a fund's assets, says Roger Edelen, a finance professor at the University of California, Davis. But transaction costs can be unusually high when a manager must sell to meet withdrawals, he says. Costs for forced trades can cut a fund's return by 1.5%.

"Trades that are done to manage flows can be very expensive," says Edelen.

Should you shun funds that have suffered big outflows? Investors should normally be wary of funds that have lost a double-digit percentage of their assets, Dolan says. But these aren't normal times. She recommends keeping funds with experienced managers who have long records of success.

Third Avenue Value Fund ( TAVFX) has lost more than half of its assets, falling to $4.3 billion from $11.1 billion in 2007. During the past decade, the fund has returned 3.6% annually, outdoing 85% of its competitors.

"Despite the problems, the strategy of the fund is still sound," Dolan says.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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