Mutual funds that own hard-to-trade debt are gunning for an advantage when it comes to returns, but they can face a big disadvantage when it comes time to sell.
They are often the weakest hand in a market of hungry experienced traders simply by virtue of their structure. They must publicly report their holdings, albeit on a delayed basis, and disclose information about investor inflows and outflows. Hedge funds, on the other hand, do not have to disclose nearly as much.
That’s like putting a huge "kick me" sign on these mutual funds when investors start asking for their money back. Because the debt these funds own may only trade a few times a year, prices are as reliant on supply and demand as the actual fundamentals of a given company. In that situation, hedge fund managers can pass up a heavily discounted bond, secure in the knowledge that there’s most likely going to be even more selling, which means even lower prices. They can just sit back and watch the quick trip to the bottom.
Exhibit A of this phenomenon is Third Avenue Management. After it decided to liquidate its $788 million mutual fund that focuses on highly distressed debt -- and to gate in remaining investors to avoid a fire sale of the remaining assets -- its chief executive hinted that the fund was a victim of just such behavior.
“Our portfolio was well known, it’s almost like we were targeted,” CEO David Barse said, according to the Wall Street Journal.
He’s probably right, but that’s the nature of the market. The demise of the Third Avenue fund, which not so long ago managed billions of dollars, rattled the $1.3 trillion U.S. high-yield market and exposed the vulnerability of the mutual-fund structure to infrequently traded debt with longer maturities.
It would be easy to contend that mutual funds just shouldn’t splash around in the high-yield pool, but it’s not that simple. Even higher-rated bonds that trade a lot may not trade much in two years, or even a year. And fund managers can balance less-traded debt portfolios with more-liquid securities, offering investors higher returns.
In Third Avenue’s case, the fund had a narrow exit even in good times. It specialized in debt that few other investors would be interested in. That’s how you get big yields. It’s also how you can get caught in a death spiral.
That’s not to say that investors should just yank their money out of high-yield mutual funds, which could both exacerbate their losses and possibly rob them of any recovery. But going in, these funds’ managers should be forthcoming about the structural disadvantage they face and prepare accordingly. They, and their investors, ignore it at their peril.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
To contact the author of this story:
Lisa Abramowicz in New York at firstname.lastname@example.org
To contact the editor responsible for this story:
Daniel Niemi at email@example.com