Over the past year, most of you have enjoyed perusing your brokerage or 401(k) statement because the balances are rising. While you may not yet have enough money to retire, at least you have more money than you had a year ago. These financial reports seem to be incredibly precise, because the value of each and every holding is priced down to the penny. In reality, some of the valuations arent quite as accurate as they appear to be. If you only invest in highly liquid individual stocks and bonds or mutual funds consisting of very liquid securities, then you can probably skip this column and tend to your NCAA tournament basketball brackets.
In order to build a more diversified portfolio, many of you have ventured into mutual funds specializing in emerging markets, high yield, bank debt, mortgage obligations, and even private investments. You probably think that the prices of those funds are as accurate as the prices for your large capitalization mutual fund or 100 shares of your favorite stock. In fact, the daily prices for these funds and the values in your financial statements are estimates. In this column were going to explore some of the special considerations that go into owning less liquid mutual funds.
Lets begin with a brief discussion of mutual fund pricing. Its easy to get accurate prices for highly liquid securities because they trade frequently, and the data are widely and consistently reported. However, many other securities dont trade regularly, and if they trade at all, the spread between the bid and ask is large. As a result, the pricing of many less liquid funds is the result of a combination of indirect pricing techniques. Asking brokers for indicative bids furnishes mutual funds with prices for some of their holdings. Other securities are valued using pricing services, which provide estimated values. And still others have to be determined using models.
For example, many of you own shares in Pimcos Total Return Fund, which is chock-full of customized derivative and swap contracts. The bank that entered into the contract and Pimco itself are probably the only two sources for pricing these contracts. In other words, it is extremely difficult to get a truly independent market view on the value of those holdings. However, as long as these techniques arent biased, the aggregate prices reported for your mutual funds ought to produce reasonable estimates.
Biased, stale pricing
Over the years, there have been numerous cases brought before the Securities and Exchange Commission as a result of biased and stale pricing. In the case of biased pricing, certain buyers or sellers have been given a systematic advantage over other shareholders because they either acquired shares at too low a price or sold at too high a price. Stale pricing occurs when the mutual fund fails to update prices. If a particular set of holdings doesnt trade very often, a mutual fund may simply use the same price for days on end without obtaining fresh brokerage bids or updating their financial models. The recent LIBOR scandal is a great example of biased pricing.
Since the financial markets seem to swoon with some frequency these days, long-term investors need to have some understanding of pricing. As markets decline, it becomes harder and harder for mutual funds to get reasonable estimates for securities that trade infrequently. In fact, the true value of your less liquid mutual fund holdings may be even lower than the figures reported on your statement. Those estimates dont fully reflect the impact if the manager actually tried to unload the securities in a weak market environment.
There arent too many ways to protect yourself when you invest in relatively illiquid asset classes. However, theres a fee that can provide you with a bit of protection; you might want to look for it when you make these types of investments. The redemption fee is charged to anyone who tries to sell a mutual fund after holding it for only a short period of time. Better yet, the fee is paid to the mutual fund, not the manager. As a result, long-term investors are given some protection from traders who might try to take advantage of pricing discrepancies in less liquid mutual funds.
Watch for patterns
If you own mutual funds that invest in less liquid securities, you should also pay attention to the overall pattern of purchases and redemptions of shares. If a great deal of new money is pouring into the fund, your manager may run out of good investment ideas or begin to stray from her strategy. If the fund is experiencing serious redemptions, the manager may be selling the most liquid holdings, which might leave you with a relatively unattractive set of holdings. Your broker should be able to monitor flows for you. If you are a do-it-yourselfer, you can get a pretty good idea whether a fund is experiencing purchases or redemptions by comparing the per-share price increase or decrease with the increase or decrease in the total market value of the fund. For example, if the fund price declines from $10 a share to $9.50 or 5 percent, while the value of the fund declines from $1 billion to $800 million or 20 percent, you have a fund that might experience some redemption pressure. You might want to avoid or sell this type of fund.
You might also consider using a mutual fund company that hires sub-advisers to manage less liquid asset classes. A firm, such as Vanguard, should be monitoring both the performance of the manager and the pricing of the fund. While its not a panacea, its useful to have an extra set of eyes looking at a funds practices. While every mutual fund is governed by a board of trustees, Ive found that these boards are a poor defense to problems in a fund, especially when the fund is sponsored by a money manager, bank, or brokerage firm.
Although bank debt, emerging market debt, or mortgage funds are offered in the same mutual fund package as large cap equity fund, theyre not the same thing. The pricing is subject to much more guesswork and the funds are prone to be less predictable during periods of stress. As a result, you have to do a little more homework and pay a bit more attention when you step away from the plain vanilla world of stock and bond funds.
Andrew Siltons Meditations on Money columns can be found twice a month in The N&Os Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/