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What’s Uber Worth?

Probably not what your fund company says.

The Eye of the Beholder On Friday, The Wall Street Journal ran a front-page story on mutual fund pricing, titled “Mutual Funds Flail at Valuing Hot Startups Like Uber.” The article revealed how mutual fund companies struggle to price the shares of private-placement securities that do not trade in the public markets. On June 30, 2015, for example, Fidelity valued the shares of Uber at $33.32, Hartford recorded a price of $35.67, and BlackRock was at $40.02. Same shares, same date, but three distinct prices.

That causes a problem for calculating fund performance. Consider the hypothetical case of a fund that invested 5% of its assets in Uber shares on Dec. 31, 2014, at a price of $18. (For example only, as we don't know what Uber was truly worth on that date, either.) Assume that the non-Uber portion of the fund’s portfolio has been flat for the year to date. By Fidelity’s accounting, that fund would be up 4.26% in 2015, thanks to the appreciation in its Uber stake. But BlackRock would say 6.11%.

The difference of 1.85 percentage points between the two approaches would be highly meaningful to our hypothetical fund’s hypothetical portfolio manager. Adopting the higher value would boost the fund’s percentile ranking against its competitors, would likely lead to a higher annual bonus, and could possibly raise the fund’s Morningstar Rating, or "star rating." In an environment where every basis point counts, collecting 185 of them at once, through a simple accounting decision, is a very large deal indeed.

The Serpent Beckons And yes, some fund companies have been tempted. The Journal article mentions the well-known example of the once high-flying Van Wagoner funds, which in 2004 settled civil charges filed by the SEC alleging that the funds had mispriced several of their illiquid securities. (Although, in fairness, some of Van Wagoner's sins appeared to be pricing these securities too low rather than too high.) Lesser-known cases include Alliance Convertible, which in the 1990s slashed in half an 8% stake in private placements the final day of its fiscal year (along with firing its two portfolio managers), and the amusing story of the government-bond fund that led the total return charts because of an overvalued stake in a private-placement issue, which was ... you'll like this feature ... the stock of the fund company itself.

Now that’s a virtuous circle! Inflate the worth of your fund company. Watch as that new, higher value jump-starts the fund’s performance so that the fund makes headlines, grabs top rankings from the fund-tracking services, and lures incoming assets. The monies flooding into the fund make your fund company more valuable, which justifies marking up the price of the private placement. Rinse and repeat. Stop when fabulously wealthy.

Well, no, that did not happen in this fund's case. Management’s scheme worked only when the fund was tiny, because the moment that the fund became large enough to attract attention, it got caught. The fund held ordinary bonds but profited because of the ballooning price of an obscure stock position. What was a bond fund doing holding a stock--and a private placement at that? That particular game ended abruptly.

But you get the point. Private-placement issues, which are valued by guesswork--gold-plated MBA guesswork supported by spreadsheets and business-school jargon, but guesswork nonetheless--offer an opportunity for the unscrupulous.

You Win, I Lose The vagaries of private-placement pricing also harms fund shareholders even when all parties act in good faith.

Consider again those Uber prices. If Fidelity’s valuation of $33.32 on June 30, 2015, was correct, then BlackRock funds that held Uber on that date were overpriced. Consequently, investors who purchased those BlackRock funds on June 30, 2015, were overcharged, while those who redeemed shares from the funds were paid too much. The second group of shareholders profited at the expense of the first group.

If, on the other hand, BlackRock’s valuation was the price that was correct, then the reverse held true for Fidelity’s June 30, 2015, investors. Those who bought into the relevant Fidelity funds received their Uber shares at bargain, while those who redeemed the Fidelity funds were not paid the full worth of their investments. As before, one set of shareholders benefited, while the other set lost.

Such was the situation in last decade's market-timing scandal: One group of shareholders profited, while the other lost. The game was zero sum. That situation, correctly, was regarded as a fund-industry disgrace and was promptly eradicated after being discovered. Wobbly private-placement prices, on the other hand, have been around as long as mutual funds have existed. The Journal's story publicly surfaced the issue, but the problem has been well known with the industry. Yet the pricing discrepancies persist.

Two Suggestions My comment to the SEC: It is time for a change.

I do not claim that Fidelity, BlackRock, Hartford, or any other company named in the Journal's story have acted inappropriately. I have no such evidence, nor do I believe that to be the case. The giant fund firms have strong risk-management and auditing functions and much to lose by gaming the system. I doubt that they would knowingly cut corners. But, regardless of motives, the result for shareholders is similar to that caused by the market-timers. That is unpalatable.

Proposal #1--Centralize private-placement pricing

I can understand why the SEC would not wish to get involved with pricing public securities. While that task is also a tricky one that can lead unethical fund companies astray, there are millions of such issues (nearly all of which are bonds). Much simpler for the SEC to proclaim best practices for valuing illiquid public securities and then to step aside than for it to become directly involved.

But private placements are another matter. There aren’t many of them, probably only several hundred of real significance. It would seem to be an easy matter for the SEC to specify how a private placement’s value is to be determined (presumably by averaging the results of several pricing systems), then requiring that all fund companies use that single figure. Voila! The discrepancies between fund companies--and the possibility of monkey business--would disappear.

Centralizing the pricing of private placements would not solve the problem of incoming shareholders subsidizing redeemers, or vice versa. God, presumably, knows the correct value for a private placement, but the rest of us only learn when the next batch of shares is sold. Ditto for the SEC’s estimate. However, at least the error in the SEC’s number will have been honestly achieved and applied equally across all fund companies. A shareholder at one fund company will not be better off than one at another.

Proposal #2--Eliminate private placements from mutual funds

That mutual funds can invest at all in illiquid securities was a side feature of the Investment Act of 1940, which specifies that 10% of a fund’s assets may be invested in “restricted” securities. (This 10% was increased in 1992 to 15%, as the SEC openly sought to assist George H.W. Bush’s re-election campaign by demonstrating its commitment to “small businesses.”)

That side feature might once have made sense, but not today, when mutual funds have become so thoroughly mainstream.

Let accredited investors brave the troubles associated with private-placement pricings, as they brave the periodic frauds by hedge funds and the obscurities of private-equity funds. Or, create a registered version of a fund that invests in illiquid securities (both public and private placements), with rules for pricing and redemptions that differ from those of traditional mutual funds. That would give mainstream investors the chance to profit from private placements, while being given the appropriate protections.

I prefer the second proposal, but the first would be fine, too. Either would be an improvement on what goes on today.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com 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.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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