Late last year, The Third Avenue Focused Credit Fund announced plans to dissolve, shocking investors and analysts and defying protections put in place by the SEC designed to prevent such an event.

This article considers how the closure highlights the need for fund liquidity and accurate valuations in all portfolios, even those with extra layers of regulatory oversight. It is by Kelly Westfall, director of investment strategy consulting at PKF O’Connor Davies, specializing in investment manager/fund due diligence, equity and alternative managers and products, and allocation recommendations as well as other types of specialized investment analysis.  

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On December 9, 2015, something nearly unprecedented happened: The Third Avenue Focused Credit Fund (TFC) announced a halt on share transactions and made public its plan to liquidate. This was the largest mutual fund failure since the 2008 financial crises. The fund’s sponsor, Third Avenue Management LLC, was started by legendary investor Martin Whitman 29 years ago and had risen to over $26 billion at one point. As of year-end 2015, the firm’s assets had dropped to around $7 billion. The fund itself began its 2014 fiscal year with assets nearing $3 billion. By December 2015, its assets had dropped to about $800 million.

In a letter to shareholders, Third Avenue CEO David Barse wrote: “Investor requests for redemption…in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable for (TFC) going forward…to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.” The letter went on to explain the illiquid nature of the fund’s strategy and the need for a longer holding period to generate positive returns. Notably, this is the first time I am aware of that the stated strategy of a fund has been used as an excuse to freeze mutual fund redemptions (which regulations require by to be available within seven days). 

On December 14, 2015, Barse and Third Avenue Partners parted ways. Barse was escorted from the building. The chaos to follow included emergency intervention by the SEC, which reversed the fund’s plan to move the assets of TFC to a liquidation trust but allowed a temporary freeze on redemptions. As the credit markets braced for the potential string of failures, interested parties began to dissect the fund and its management.

When funds close

It is not unusual for investment funds to dissolve, especially those with niche or concentrated, high-risk strategies such as this one.

According to the Alternative Investment Management Association (AIMA) Journal, up to 10 per cent of hedge funds trading each year close and liquidate. However, TFC was not a private hedge fund, but rather an open-end, non-diversified, Securities and Exchange Commission (SEC) registered investment company under the Investment Company Act of 1940 - more commonly known as a “40 Act” mutual fund.

The portfolios of 40 Act funds are subject to rules and portfolio limits aimed at protecting retail investors. These protections differentiate mutual funds and exchange-traded funds (ETFs) from hedge funds, the shares of which are only deemed suitable for sale to high-wealth, sophisticated investors. Mutual funds are considered the bastion of safety and, along with ETFs, are seen as sources of liquidity. In fact, the SEC lists liquidity as one of the four reasons people buy mutual funds.

In the US, 40 Act funds are subject to regulatory mandates which generally include concentration limits on investments in securities and issuers of securities. There are also limits on illiquid assets described by the SEC as assets “which may not be sold or disposed of in the ordinary course of business within seven days.” Lastly, 40 Act funds must price the portfolio daily and report holdings at least quarterly. These limits and reporting requirements are intended to protect against catastrophic liquidity events similar to the TFC closing. 

The rotation of “40 Act” products

Yet, hundreds of registered mutual funds close and liquidate every year, even while a deluge of new products are brought to market. To compete with low-fee index funds, issuers began launching a blitz of “alternative” mutual funds and ETFs which mimic hedge fund strategies. Contemporaneously, issuers have pressured regulators to allow more esoteric strategies to come to market as registered funds. Vanguard chairman and CEO Bill McNabb told CNBC’s Bob Pisani that “product proliferation has reached epic levels.” 

While ETF investors have been less enticed to invest in alternative funds, the Division of Economic and Risk Analysis (DERA) reported in September 2015 that although alternative mutual funds make up 2.6 per cent of the market, “alternative strategy funds are growing faster than any other category.” Conversely, the 2014 EDHEC ETF Survey noted that satisfaction among users of ETFs with hedge fund strategies is erratic and lower than other strategies. According to the survey, “volatility in satisfaction rates with ETFs based on illiquid asset classes may also be due to the suitability of ETFs for more liquid asset classes.” The result has been a surge of fund openings and closings.

When a mutual fund closes, however it typically does so in an orderly fashion. The fund first closes to new investors, then current investors are generally given several months to redeem their shares when fees are typically waved. 

So how is it possible that TFC closed so abruptly? The fund’s closure exemplified the exact outcome the SEC aims to prevent: an inability to meet redemptions within seven days at the fund’s stated net asset value (NAV). In addition to highlighting the inability of regulators to ensure the liquidity safety net associated with registered funds, it also reveals the false level of security investors have enjoyed.

 
Regulators focus on liquidity rules and monitoring

Regulator concerns over 40 Act fund liquidity and valuations have been building. In fact, on September 22, 2015, the SEC announced that the Commission “voted to propose a comprehensive package of rule reforms designed to enhance effective liquidity risk management by open-end funds, including mutual funds and exchange-traded funds.” At the time of the TFC closing, the Commission was in the process of reviewing. Then on January 13, Reuters reported that “securities regulators launched a review of potential liquidity risks posed by high-yield bond fund managers in the aftermath of the collapse of Third Avenue's junk bond fund.” The article noted regulators gave fund managers just 24 hours to turn over portfolio pricing and liquidity details.

Understanding mutual fund liquidity and valuation risk

The TFC closure spotlights two primary risk factors: fund liquidity and valuations.

Fund liquidity

Underlying liquidity and investment flows: According to EDHEC, “the liquidity of an ETF is determined by the liquidity of the underlying securities. If the underlying securities are illiquid, it is to be expected that the ETF will be illiquid.” Additionally, the DERA report noted that alternative strategy funds face more volatile flows compared to more traditional funds - “during the period 1999 through 2014, the average standard deviation of monthly flows for alternative strategy funds was 13.6 per cent, compared to only 5.8 per cent for US equity funds.”

The volatility of flows to alternative funds, combined with the illiquid nature of the portfolio, limits the ability to maintain a fund’s asset base — a primary determinant of fund success or failure.

Liquidity gates: Registered funds do not have contractual liquidity gates. However, this may not prevent them from establishing one. Almost all hedge funds contain at least one contractual discretionary gate which allows fund managers to freeze redemptions when it’s deemed to be in the shareholders’ best interests. Additionally, most hedge funds contain other gates which can be triggered for a variety of reasons.

Contractual liquidity terms versus reality: When a fund’s portfolio is illiquid, the fund is also illiquid. If the liquidity of a fund’s strategy and/or holdings is inconsistent with the fund’s stated liquidity terms, the chance of a redemption freeze increases. Within this structure, shareholders experience both realized losses and missed opportunities if the fund experiences large redemptions whether or not there is a gate. Investors who redeem from a mutual fund during the day transact at the fund’s end-of-day NAV. However, when the fund’s holdings are illiquid, the transactions associated with meeting those redemptions typically occur on subsequent days. As a result, the costs of providing liquidity to investors are partially or entirely borne by the non-redeeming investors. As the “best” most liquid assets are sold to meet redemptions, current investors are left with the remaining less liquid assets.

When hedge funds face extreme redemptions, gates are enforced and the liquidity terms of the fund become irrelevant.

If a fund is event-driven or seeking distressed and high-yield debt opportunities (similar to TFC), the liquidity of the fund is not daily or probably even monthly, regardless of the fund’s stated terms. The fund may maintain enough cash to handle a normal level of redemptions. But as an investor, the goal is to put money to work, not to enable the fund to grow more assets by proclaiming more frequent redemptions. Third Avenue’s website described TFC as: “A portfolio of high-yield stressed and distressed securities with investments throughout the capital structure (high-yield bonds, bank loans, convertible securities and/or preferreds) and across the credit spectrum.” This description does not depart from the fund’s actual strategy. However, its suitability for a mutual fund is questionable.

Illiquid asset classes: Other strategies such as distressed debt, private equity holdings, frontier and emerging market stocks and bonds, preferred equities and material holdings in small cap equities are far less liquid than investment-grade bonds and large cap equities. Funds that focus on less liquid asset classes are negatively affected by offering similar redemption terms as funds holding highly liquid assets.

Valuations

Pricing illiquid assets: Mutual funds are required to compute a NAV daily and issue redemptions at share prices determined at the current day’s close. Illiquid assets are difficult to value and subject to modeling error as well as subjective pricing. Certain categories of fixed income securities in particular are rarely traded. In the absence of transactions to support pricing, funds determine pricing based on “dealer quotes” and models. Dealer quotes may be hand-picked by the fund based on relationships or the attractiveness of their quotes. Models are opaque and prone to error and subjectivity.

Daily math: A mutual fund manager who closed a credit fund during 2014 told me one of the biggest reasons they shuttered their fund was the difficulty of meeting daily pricing regulations. There were constant revisions and regulatory filings associated with the daily computations.

The facts as we know them seem to indicate TFC’s percentage of illiquid assets exceeded regulatory limits. There is also a real possibility that TFC’s valuations were not accurate.

While the industry waits for regulators to respond, what should investors do? Absent a review of the fund’s strategy and underlying assets, the liquidity of the fund and the reliability of published valuations cannot be fully understood. Thus, the fund’s allocation role in a portfolio may not match one’s goals and risk limits. Harry O’Mealia, CEO of 1919 Investment Counsel, advises that one cannot rely on regulators to stay ahead of product marketing. “Unless you are reasonably sophisticated and are willing to put the time in to really understand what you own and why you own it, you should surround yourself with advisors whose judgment you trust.”