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Rekenthaler Report

Do You Own a Grab Bag?

Not every mutual fund is accurately priced.

(Un)Fairly Valued
When I was young and collected stamps, I occasionally would buy the $1 "grab bag." The grab bag was a mystery selection; you didn't know ahead of time what it held. Perhaps there would be a hidden treasure? Or so the advertising went. Of course there were never rarities in the grab bag, only the commonest stamps. But there was still the thrill of discovery in learning which mundane stamps were in the  packet, and it was a good starter kit for assembling the basics of a collection.

Some mutual funds are grab bags, too. Unlike with stamps, however, mutual fund grab bags can contain surprises, and almost uniformly unpleasant ones at that. I refer to the discovery that a security in a fund is worth less than its official price. (It is very rare indeed when a security is found to be worth more than its stated value.) The fund's net asset value is then abruptly marked down, and inequities are introduced. Those who bought the day before and who sold the next day end up subsidizing those who sold the day before and bought the day after.

This can happen with more mutual funds than you think, and at a greater scale. Consider, for example, five mutual funds run by Morgan Keegan. Directors for these funds recently settled SEC charges that had been issued against them. The settlement itself (a mild rebuke) is not significant for this tale. However, the details that emerged from the process certainly are relevant. Namely, the SEC learned "in most cases" with the five funds, securities that were priced by a Morgan Keegan committee establishing their "fair values," rather than priced in the open market, made up "above 60 percent of the portfolio."

Well, that's comforting. For most assets, the fund company gets to appraise its own goods. (I did that once with my house, informally, and came up with a value that was 120% of the house's actual sale price.) As a shareholder, I have no idea how this process is conducted. Perhaps the fox is guarding the henhouse, with the portfolio manager claiming that his knowledge of those markets makes him best positioned to value those assets. (Rumor has it that is indeed what occurred at Morgan Keegan.) One day I could look up and receive a surprise.

What's more, any risk statistics describing the fund's volatility are suspect. Securities that are priced using "fair value" estimates don't change prices daily. In Morgan Keegan's case, the SEC found that many securities stayed at the same fixed and inaccurate price for weeks at a time. So, funds that may well carry more risk because they own illiquid and possibly exotic securities show up as having less risk via typical calculations such as standard deviation or, yes, Morningstar Risk as used in the calculation of the Morningstar Rating (or "star rating").

It's impractical to suggest that mutual funds be banned from investing in securities that must be priced via the fair-value method, or even that they be limited to a certain percentage of assets. That would remove mutual funds from several fixed-income markets; in particular, it would be a real problem for municipals. But it would be useful for funds to state, upfront, what percentage of the portfolio is fair valued. The figure could be prominently positioned in the prospectus as a range and in the shareholder report as an exact number. Morningstar and other fund researchers could then treat those funds' volatility statistics with the caution that they deserve.

Speaking in Silence
The media noticed last week when Standard & Poor's raised its credit outlook on U.S. debt to stable from negative, but the markets certainly didn't. U.S. bond prices fell the day of the announcement, signaling that investors really, truly did not care.

Credit ratings of the debt from major governments, which issue massive amounts of information about their financial statuses and which are closely scrutinized by the global investment community, are pretty much pointless to begin with. The joke is often made that by the time a credit-rating agency recognizes reality and downgrades a country, all the sellers are gone and it's time to buy. That is not strictly true, but it's very difficult for a rating agency to bring new data and new insights to the process. In the case of the United States, it's impossible. The markets will always issue a collective yawn.

Today's The Wall Street Journal discusses how oil traders profit from gaming the spot-price market. The lead example shows how a trader buying a large quantity of oil could sell a smaller quantity of oil at a loss and report that new lower price to a pricing agency, which would promptly mark down its estimate of the spot price. The trader would then buy the large quantity at the lower price, thereby saving (large quantity - small quantity) * (higher price - lower price).

I'll leave it to others to debate if the trader's activities represent a productive use of human resources. What interests me is the tactic's simplicity. After all, it scarcely requires a concentration in econometrics and statistics to bluff a pricing agency. All those MBAs trained to use sophisticated quantitative methods, at $100,000 per degree, and yet some guy somewhere is profiting from a very simple game of move the price and buy lower. There might be a lesson in there somewhere. 

The Wireless Game
My wife and I have different smartphone providers. One has Verizon, the other T-Mobile. My wife derives ongoing amusement from my inability to get on the Internet when we are running errands, along with periodic episodes of losing cell-phone range so that I cannot make a call. In almost every instance, her phone is functioning fine. Can you guess which person has which carrier?

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.