Will Your Mutual Fund Return Your Money?

Addendum--

In response to this article, Third Avenue raises two points.

1. Third Avenue states that although the original plan was to create a liquidating trust, management modified that plan so that the fund would remain in its original structure. This did not alter the situation for shareholders. The fund continued not to accept redemptions, and proceeded with its plan to liquidate its assets over time and disbursed the proceeds.
2. Third Avenue disputes the statement that it misstated the price of any of the fund's holdings. It maintains the the fund's 2018 write-down came from the revaluation of a single security, which occurred because of a corporate action, not because the security originally had been mispriced. Morningstar accepts this explanation, which does not change the essential facts for the purpose of this column: Registered mutual funds on occasion are unable to meet shareholder redemption requests, in which case it may be quite a while before shareholders get their money back, and they may not receive 100 cents on the dollar, either.

A Reader's Question Mr. Henning inquires, "What happens if a fund no longer has the cash to redeem shares?" Presumably, management would sell securities to raise cash. In some instances, though, that is not feasible, because the portfolio's holdings are so illiquid that they cannot be moved immediately. The shareholder who wishes to redeem must wait.

This was the situation with one of Henning's investments. He writes, "The fund managers asked up to five years' patience from shareholders in order to sell the real estate that the fund owned. After almost five years they had sold only about 50% of the assets. Meanwhile, they claimed management costs of about 3% to 4% per year."

Lovely.

The good news is that this fund was not sold in the United States, and could not be. Unlike with American real estate mutual funds, which purchase real estate investment trusts that trade as stocks, many overseas real estate funds own property directly. Obviously, property takes longer to trade than do REITs (although taking more than five years to wind down the fund's positions, while collecting management fees, seems to be taking things altogether too far).

Indeed, long-standing U.S. mutual fund rules would have seemed to preclude such situations entirely. Per the Investment Company Act, the SEC has traditionally prohibited funds from investing more than 15% of their assets into issues that cannot be traded within seven days, at an amount approximately equal to the price that the fund has valued the security. No mutual fund, to my knowledge, has ever faced one-week redemption demands that equal 85% of its assets.

Third Avenue's Pratfall This stricture, however, has not prevented the occasional U.S. mutual fund from running into trouble. The most notorious case was Third Avenue Focused Credit, which announced in December 2015 that it was ceasing operations. Poor performance had begot redemptions, which forced the fund to move its low-grade bonds faster than the market normally permitted, which depressed their sales prices, which hurt the fund's net asset value, which begat additional redemptions. Management said, "No mas."

Fund companies routinely shut down funds, but this time was different. Normally, companies notify shareholders that the fund in question will be terminated as of a given date. Investors may redeem their shares in the interim, or they may await receipt of the final proceeds. Third Avenue altered both conditions. There would be no interim, nor a stated liquidation date. Instead, the fund's assets were immediately and abruptly placed into a trust, which would gradually disburse monies as the investments were sold.

Third Avenue expected the process to take "up to a year or more to complete." More than two years later, in February 2018, the fund still existed. It then marked down its remaining positions--which represented about 20% of original value of the portfolio, the remainder having been paid out--by more than 50%. In a single day, the fund's NAV dropped to $0.51 from $1.12.

Lovely.

Naturally, the fund's liquidation process triggered a lawsuit, which eventually ended with Third Avenue settling with a $14.5 million payment. While Third Avenue's parties did not officially admit to wrongdoing in the agreement, it was pretty clear that the fund had: 1) Greatly exceeded the 15% limit on illiquid securities and 2) misstated the prices at which some of those issues could be sold (thus, the big write-off, as management acknowledged the gap between how the fund valued those holdings and how the market did).

Related Troubles Several years before, during the financial crisis, Schroder shut down two municipal-bond funds, in October 2008. As with Third Avenue Focused Credit, shareholders were not given the opportunity to redeem their shares after the announcement. They were forced to wait until December 2009 for their payouts, which, happily, were only slightly less than the funds' stated NAVs: 99 cents on the dollar in one instance and 97 cents in the other.

In addition, Morningstar is aware of at least one instance in which a high-yield municipal-bond manager requested from the SEC that it be permitted to delay redemption demands, owing to liquidity concerns. The SEC denied that request.

In short, 1) although SEC regulations appeared to be sufficient for preventing liquidity woes, on occasion U.S. mutual funds have been forced to limit investors' ability to redeem their shares; and 2) such cases, at least to my knowledge, have always occurred with fixed-income funds. Stocks, by and large, trade. The same cannot be said for the more-esoteric corners of the bond market, wherein (it sometimes is said) the securities "trade by appointment." This holds particularly true for municipal bonds, which are the most diffuse of marketplaces.

The Commission's Response Recognizing this problem, the SEC recently enacted an amendment to the Investment Company Act of 1940 that improves liquidity disclosure. (Admirably, this amendment was drafted before Third Avenue's implosion, although it wasn't implemented until this past summer.) Each mutual fund (and exchange-traded fund) must now adopt and implement a Liquidity Program, which mandates that it assess and monitor its liquidity risk. In addition, it must classify all holdings as belonging to one of four liquidity buckets, and must place a minimum amount--which varies by fund--into the most liquid of the four buckets.

Whether this will prevent all future redemption problems is unclear. My guess is not; despite the regulators' best intentions, some combination of extraordinarily bad market performance, an exotic portfolio, and unexpected shareholder behavior will create a crisis. That said, it's fair to assume that what historically has been a rare event will become even rarer.

In short, Mr. Henning, you will be unlucky indeed if your redemption request for a U.S. mutual fund is delayed. The possibility exists, but it is very low--particularly with equity funds and with high-credit fixed-income funds.

The Canary in the Coal Mine? The current economic expansion is almost 10 years old, which makes it the second-longest expansion in U.S. history, after the 1990s' boom. That does lead one to wonder when the cycle will turn. Recent news that monthly U.S. retail sales posted their largest monthly drop in nine years, and that more Americans are behind in their car payments than ever before, therefore cause me concern.

I'm no economist; these might be blips, not meaningful signs. But given the length of the expansion, and the stock market's recent strong showing, I am in no rush to put my portfolio's 10% cash position to work.

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.