ON GOOD DAYS

mutual fund manager Bill Nygren arrives at his downtown Chicago office an hour before the stock market opens and plots what investments to add to the 20 or so holdings in his

Oakmark Select fund

Lately, there haven't been many good days. Sure, a down stock market should reveal dozens of potential bargains. And Nygren and his team have one of the best long-term records among value mutual fund managers. But there's just one problem: He's a fund manager who can't, well, manage funds. Investors, spooked by the market and sensing better opportunities elsewhere, are consistently pulling money out of Oakmark Select, and Nygren doesn't have enough money to buy the shares he wants to buy even though he's finding plenty of bargains. While he still has confidence in the fund's long-term strategy, he just can't get ahead in the short term. "You are selling stocks you would rather be purchasing," he says.

As if trying to beat the stock market weren't a big enough challenge, U.S. stock-fund managers are encountering a problem that's potentially trickier: trigger-happy customers. Although it's not surprising that the market's fall would increase sell orders, the pace of today's nervousness has caught many managers off guard and taken money right out of their hands. Since the recent market downturn started in October, investors have withdrawn almost $69 billion more from domestic stock funds than they have deposited, moving much faster than they did from 2000 to 2002, when they endured two straight years of terrible market returns before throwing in the towel. Fund managers say it's both stressful and frustrating. It makes it difficult, if not impossible, to add the best investments to their funds. And it hits them in the pocketbook: They get paid based on a percentage of the assets they manage, and those assets are dwindling as investors pull money out of stock funds.

But mutual fund managers aren't the only ones hurt by panicky shareholders. Indeed, Wall Street experts worry the bigger losers may be the investors themselves. The redemptions are taking money away at precisely the moment when seasoned managers want to scoop up bargains in their favorite companies after all, the time to buy good long-term companies is when their stock prices are lower, not higher. Meanwhile, a flood of withdrawals makes the funds less efficient and can generate extra taxes. In the worst-case scenario, fund managers have to dump stocks at low prices just to meet shareholder demands for redemptions. Roger Edelen, a finance professor at the University of California, Davis, says that kind of forced trading whether it's selling or buying is costly, lowering annual returns by 1.2 percentage points a year on average. Gregory Kadlec, a finance professor at Virginia Tech, puts it another way: It's "a dead weight on performance."

Of course, investors have reasons to put fund managers on a short leash these days. When tech stocks crashed early in this decade, many Americans were left with steep financial losses and even deeper psychological scars. For those who stuck it out, it took years for their portfolios to recover. Now when things go bad, "people vote with their feet," says Bruce Harrington, managing director of the financial-consulting firm Cogent Research. What's more, impatient investors have a lot more options beyond mutual funds. With improved technology they can simply trade stocks on their own or try other investment tools.

For Nygren, whose fund was off 8 percent in the first quarter of this year, following a decline in 2007, the steady withdrawals mean he can't buy more of his favorite stocks, like credit card giant Capital One Financial. For others, like Cohen & Steers portfolio manager Rick Helm, it has meant selling a stock he likes (Monsanto) to raise cash to buy a stock he really likes (Aflac). Some are so upset by it all that they don't want to talk about it. Legg Mason, which for years enjoyed a reputation as one of the best stock pickers and fastest growers in the mutual fund universe, saw more than $3 billion withdrawn from its funds in just the first two months of this year, including more than $800 million from Legg Mason Value Trust. That fund, run by superstar manager Bill Miller, has been tripped up lately down nearly 20 percent in the first quarter by big losses in financial stocks like Bear Stearns.

For more SmartMoney Magazine features, turn to the June issue.

But small funds may be suffering most of all. The smaller the fund, the less likely it is to benefit from the steady flow of money from corporate plans like 401(k)s. And a few bad days can get a small-fund manager in serious trouble. In early January, Mark Coffelt looked like a genius for selling short the shares of home builders in the $65 million Empiric Core Equity fund. But on Jan. 22 the Federal Reserve unexpectedly cut interest rates. Home-builder stocks soared, and Coffelt's fund got hammered. One adviser called and demanded to know what was happening to his clients' money. "I was one day away from losing 10 percent of my fund," says Coffelt, who managed to calm the adviser down. (See "Skin in the Game" on the next page for a look at how one fund company is handling the market.)

A Money Drain

THE MUTUAL FUND INDUSTRY

, of course, has plenty of experience handling redemptions, averaging nearly $6 billion a day last year. And while some funds have been hit hard, overall redemptions are still a small fraction of the $6 trillion in assets in stock mutual funds. The best fund managers are usually able to easily handle all this and continue to pursue their own buying and selling strategies. It is these strategies and keen eyes for good investments, naturally, that have made some managers stars in their field and helped turn the fund industry into the bedrock of American retirement plans.

But even stars need some wiggle room, and many have watched what started as a trickle of withdrawals become a flood. For many the contrast with past performance in shaky times could not be more pronounced. From 2000 to 2001 investors added a net $194 billion to U.S. stock funds, even as the Standard & Poor's 500 index lost a quarter of its value. It wasn't until 2002 that they started taking big withdrawals from stock funds. Now they're not wasting any time cashing out. As fund managers are quick to point out, the country wasn't even in a recession, and yet net redemptions amounted to, on average, a remarkable $600 million a day from October 2007 through January of this year. A rally spurred investors to add money in February, but it didn't last. By March the skittishness returned: $9 billion in net redemptions through the middle of the month, according to data from research firm AMG.

For their part fund clients say quick triggers are needed in a market so volatile. Some bitterly note that it was just last fall when fund managers were buying up financial stocks only to see that "bargain hunting" strategy backfire. Even investors confident in their fund managers say they're just too nervous to ride out the bad times. "If you wait until you see the market heading south, it's already too late," says Mike Shimko, a 53-year-old marine engineer in Crofton, Md. Shimko sold his shares of Nygren's Oakmark Select, which accounted for nearly 10 percent of his investments, and put his money in cash and bonds. Today that's hardly his only option: With improving technology and new products, he can go online and trade stocks much faster or buy exchange-traded funds. ETFs, baskets of stocks that are cheaper and more tax-efficient than most mutual funds, exploded onto the scene in recent years, growing to $560 billion in assets.

But while fund managers say today's nervousness is more than understandable, it also undermines the kind of long-term investing strategy that boomers, in particular, need to follow. Despite Oakmark Select's short-term troubles investors withdrew $252 million from the $3.5 billion fund in the first two months of the year it has outpaced the S&P 500 by an average of nearly five percentage points a year over the past 10 years. Indeed, history has shown that investors pull money out of mutual funds whose styles are out of favor at exactly the wrong time.

Value funds, which invest in companies trading below their perceived worth, saw massive redemptions in 1999, a year before the majority of them outperformed the market. The last time redemptions for all U.S. equity funds hit a peak was July 2002, just before the entire market took off on a nearly five-year run. Experts point out that investors are also hurt when the market finally turns higher. As investors rush back into funds, managers have to scramble to buy stocks, bidding up their prices.

Beyond that, it's simply frustrating, fund managers say, to be in the business of researching equities and having your hands tied. "The shareholders don't want to buy into something where they can't see the light at the end of the tunnel," says Helm, of Cohen & Steers. His fund, Dividend Value, has seen its net inflows slow to a trickle. Helm suspects certain big banks might be bargains, but he is leery of adding them now. The last thing a fund manager wants is to anger his customers with stocks that go nowhere or worse, might have further to fall.

Increasingly, fund managers' days are caught up managing the flow of money. In a typical year fund managers see about $3.5 trillion going into or out of their funds, but that number could climb by $500 billion this year, estimates Alan Seigerman, chief operating officer of ReFlow, a firm that provides cash to funds that are short of it when there are redemptions. That could force managers into more trades they'd rather not make, since about 30 percent of fund trades are based on flows into or out of the fund. (The rest are trades based on investments the manager wants to make.) "It's not the best of circumstances for a shareholder," Seigerman says.

Still, most managers say they're a long way from panicking and assume their clients will come back. In Chicago, Nygren says his Oakmark Select fund keeps about 5 percent of its assets in cash, so he isn't forced to sell or take out a loan. He hopes to be able to buy more Capital One once investors calm down. To soothe nerves Nygren has sent out two extra letters to shareholders, supplementing the fund's usual quarterly statements and conference calls to financial planners. In recent months he's even put more of his own money into his fund. "The redemptions don't undermine my confidence," he says.

Additional reporting by Nicole Bullock