Shortly after the Federal Reserve raised interest rates by 0.25%, Ms. Yellen issued a blanket warning about potential mutual fund failures. Her comments were in response to the recent failure of a mutual fund, Third Avenue Focused Credit, which was unable to meet shareholder requests for redemptions. She mentioned that the Federal Reserve was concerned about 29 other funds that also have the potential to fail.
While this sounds alarming at first blush, it really is a problem for a very limited subset of hedge funds and funds that invest in bonds of financially distressed companies.
Mutual Fund Liquidity and Hedge Fund Liquidity
Open-end mutual funds have guaranteed daily liquidity. Shareholders can redeem (sell back) their shares to the fund on any day the markets are open and receive cash at settlement the following day. Open-end fund managers keep sufficient cash on hand to cover normal redemptions and they invest in liquid securities (stocks, bonds, etc.) that can be sold on any given day. Furthermore, most mutual funds are diversified and refrain from developing excessive concentration in a single security. In the unlikely event they are unable to meet investor demand for liquidity, they usually have a line of credit available as a rarely-used backstop.
Hedge funds and distressed bond funds in contrast often own concentrated positions in illiquid securities that cannot be readily sold and often must be held until their maturity. For this reason, most hedge funds only offer to buy back shares on a quarterly, semi-annually or even on an annual basis. These liquidity restrictions are required to match the limited liquidity of the underlying assets.
Third Avenue’s biggest problem was their use of a mutual fund structure with daily liquidity to hold very illiquid assets. It was a hedge fund dressed up to look like a mutual fund. Because bonds don’t trade on electronic exchanges, it is very difficult to sell large amounts of risky bonds over a short period of time. In some cases, Third Avenue Value owned all or nearly all the bonds of a given company, which made it nearly impossible to sell these bonds over any short period of time. The fund’s investments were highly-concentrated in a small number of companies with very low credit quality.
This led to a fire sale scenario where Third Avenue Focused Credit would have been forced to dump its assets at pennies on the dollar. Fund management sought relief from the SEC so they could proceed with a more orderly liquidation over a 12-month period to preserve as much shareholder value as possible. The SEC granted this relief.
In the case of Third Avenue and the other mutual funds that have the Fed concerned, their daily liquidity requirements could not be met because their underlying holdings are concentrated in a small number of thinly-traded, low credit quality (C rated or unrated) assets.
Are Any of These Funds in a Focus Investment Portfolio?
No. A Focus managed portfolio does not own any hedge funds or mutual funds that invest in bonds of distressed companies.
Many of our clients do own a floating rate bank loan fun (Fidelity Floating Rate Bond Fund). This is a well-diversified, conservatively managed fund and they maintain adequate cash reserves to meet possible redemptions.
Bank loan funds are attractive in a rising interest rate environment because the interest rates on these loans typically reset every 90 days once the 3-month LIBOR rate reaches 1%. With yesterday’s rate increase, the LIBOR is at 0.53%. One or two more rate increases will get us to that 1% floor and bank loan funds will provide some much needed yield. We will continue to limit our clients’ exposure to this type of fixed income because of the credit risk.
Two years ago when the first hedge fund masquerading as a mutual fund came out, we felt this was an accident waiting to happen. Turns out, we were right.
All in all, we wish Ms. Yellen had been just a bit more specific about the risk to 29 quasi-hedge funds, than going on record with her warning about a “failure of more mutual funds”.