The news on December 10 that Third Avenue Management had suddenly closed down its Third Avenue Focused Credit Fund (TFCVX), while imposing “gates” to restrict shareholder redemptions, took many advisors by surprise.
Some weren’t aware that the Investment Company Act of 1940 allows mutual funds to indefinitely suspend redemptions – and indeed the law allows this only in emergencies.
The SEC’s own guidance for Investing Wisely in mutual funds states: “Mutual fund investors can readily redeem their shares at the current NAV — plus any fees and charges assessed on redemption — at any time.”
As Morningstar noted in its coverage: TFCVX had experienced $1.3 billion in net outflows through the first 11 months of 2015 and its total return was -27% year-to-date through early December.
However, other mutual funds have experienced similar impacts, without liquidating and gating.
Could advisors have foreseen this situation in their due diligence, and taken steps to protect investors from losses, uncertainty and lack of liquidity?
The answer is – perhaps so, if they knew where to look.
For fixed-income funds, Morningstar reports the percentage of assets in “not rated” bonds, which was 41% for TFCVX. That should have been red flag #1 for investors concerned about liquidity.
But to really protect clients, advisors must dig deeper – into the Notes to the Financial Statements of the most recent annual or semi-annual report.
These notes break down portfolio holdings into three levels: Level 1 reflects unadjusted prices quoted in active markets for identical assets; Level 2 reflects valuation inputs other than quoted prices that are observable; Level 3 reflects unobservable inputs, including the fund’s own valuation/pricing assumptions. High amounts of Level 2 and 3 assets are red flag #2.
TFCVX reported total assets on 4/30/15 of $2.3 billion, of which 74.4% were Level II and 17.3% were Level III. Just 8.4% of the fund’s portfolio was in the Level I category for which daily quotes were readily available.
This created a problem not only for purposes of liquidity, as the fund’s redemptions accelerated. It also meant that orders to buy or redeem fund shares were made at NAVs that were estimates at best and guesses at worst.
It’s important to note that short-sellers were largely responsible for TFCVX’s demise.
They could see from public records the huge concentration in Level II and II assets and also the specific illiquid high-yield bonds the fund held. This transparency is a special hazard of high-yield and emerging market bond mutual funds.
Since TFCVX’s demise, it has been cited as one of the best reasons to pursue exposure to these asset classes through either ETFs or closed-end funds, neither of which have the same vulnerabilities to redemptions or short-sellers as mutual funds.
If you recommend high-yield or emerging market bond funds, make sure to learn the lessons of this fund’s demise.
The due diligence to uncover red flags isn’t very difficult or time-consuming, and it will become more important going forward. In months to come, there is nothing to prevent the predatory tactics of short-sellers or the liquidity/gating of investors from being repeated with other mutual funds in these categories.
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