If you listened to any of the managers or marketing teams of any mutual fund firm in the weeks that followed the implosion of the Third Avenue Management junk bond fund in the final weeks of 2015, you would have heard a long litany of all the reasons why it was important not to worry.
The assets in Third Avenue’s Focused Credit Fund were particularly “junky”; of notably low credit quality and particularly illiquid, you’d be told, making it an outlier even in the riskiest corner of the mutual fund universe. It’s simply not representative of the kind of mutual fund that the vast majority of investors will own. Then, too, the fund’s management company didn’t even suspend redemptions; at least, not technically. Rather, it simply transferred the fund’s $789 million of assets into a liquidating trust, whose assets will then be frozen.
Still concerned? Well, you can take comfort in the fact that this is only the first time since 2008 and the height of the financial crisis that a mutual fund has effectively closed its doors, the Pollyannas will reassure you. Then, too, in spite of the fact that Third Avenue’s meltdown took place amidst a volatile period for the high yield market and itself exacerbated that volatility, the damage appears to be contained: no other high yield fund closed its doors, in spite of the ongoing turmoil in the sector.
The Securities and Exchange Commission isn’t buying all that happy talk, and nor should anyone else. While calm has been restored to the funds world in the weeks that have elapsed since Third Avenue’s closure hit the headlines and roiled the markets, there is plenty happening beneath the surface. And if you’re not preparing to handle back office and marketing challenges related to matters raised by Third Avenue, you risk being caught unprepared in the months to come.
The truth of the matter is that what happened at Third Avenue was a dramatic departure from history. Until December 2015, no mutual fund had ever blocked an investor’s ability to redeem their holdings unless the SEC had explicitly authorized it to do so. And now the SEC is in the midst of reviewing just how it happened that Third Avenue did this, and reviewing the potential liquidity risks posed by other high-yield bond fund managers.
The Fate of a High Yield Market
Specifically, regulators want to know how funds price their least liquid investments – those for which there might not be an easy market, such as a rarely-traded bond. Often these securities are tough to price correctly, because they trade so rarely, and so also can be carried on a fund’s books at a value that is well above what they would actually fetch if the manager ever tried to sell them on the open market. One of the other questions the SEC is posing is whether investors have challenged fund managers’ valuations of these holdings.
While it’s not likely that regulators will make the results of their probe public – after all, signaling that Fund Company XYZ’s liquidity quality gave them cause for concern would hardly help restore confidence in the mutual funds universe – there are plenty of steps that both mutual funds can take to reassure investors that they are aware of what these risks are, and to not put them in the place that Third Avenue’s investors found themselves in the months leading up to the December blowup. In that context, Third Avenue seems to have almost deliberately misled its investors, reassuring those that voiced concerns about the growing proportion of hard-to-trade Level 3 assets (categorized as illiquid) that the fund had plenty of cash. Others who refused to be appeased got out in time.
Going forward, and with questions hovering over the increased market volatility overall, and the fate of high-yield market and specific sectors, such as energy, in particular, the mere fact that Third Avenue Focused Credit Fund did collapse makes it all the more important for other fund companies to address their own systemic risk factors more proactively.
Until this point, a mutual fund’s risk has been conceived of in terms primarily in terms of its performance: will it or won’t it deliver the kinds of returns promised by its manager? The definition of a fund blow up remained a mutual fund in a sector that suddenly imploded, as technology stocks did when the dot.com bubble popped in early 2000, or whose manager inexplicably completely failed to deliver returns approximating those of the benchmark. Now, that definition is shifting, and so is the marketing discussion surrounding risk.
Some suggestions include clear communication of the nature of the fund’s strategy as it relates to liquidity. If the fund invests primarily or exclusively in stocks that form part of the Standard & Poor’s 500-stock index, well, liquidity isn’t going to be much of a problem, unless the entire financial market seizes up – in which case, investors will have problems with every aspect of their portfolio. On the other hand, if the fund invests largely in smaller stocks or in overseas markets where liquidity is more constrained or may become more limited in certain circumstances, it’s worth spelling out to investors up front just what those situations are and what plans the fund managers has put in place to deal with a situation of this kind. What limits do they place on their holdings of more illiquid securities, to reduce the chance that liquidity constraints could cause portfolio losses? Do they respond to market movements by adjusting illiquid positions? What other risk management policies do they have in place?
By spelling all this out ahead of time, fund managers will help ensure that they avoid a wave of panic selling, which in itself can make managing liquidity even more challenging. Fund managers can not just disclose data like their proportion of Level 3 assets, their estimate of the time it would take to liquidate their portfolios and other critical liquidity data, but highlight it, to reassure investors that they are taking the lessons of Third Avenue’s collapse seriously.
Doing so would at least demonstrate to regulators that the industry isn’t just being lulled into a sense of false security by the fact that Third Avenue (so far, at least) has been an isolated event. That could prove important, given that the SEC appears keen to implement new rules proposed last fall, requiring both mutual funds and exchange-traded funds to have on hand a certain amount of cash to meet redemptions and to put in place a liquidity risk-management program.
The uncomfortable truth is that Third Avenue is a reminder of what could be; of the argument that participants in the $18 trillion fund management industry can rank alongside big banks as a source of risk in today’s financial system. One way or another, fund managers that pursue yield at the expense of the ability of their investors to redeem and retrieve their capital won’t be welcome. Those that are able to get ahead of their rivals by managing the risk and disclosing it in a coherent fashion will be the winners, both now, by attracting capital from savvy investors, and later, as they display their risk management prowess.