Do other mutual funds besides Heartland rely on internal estimates to value portfolio holdings? You bet.
Bank loan mutual funds, commonly touted for offering high return with low risk, typically yield 2-3% more than most money market funds. These funds buy senior, usually secured, commercial loans issued by sub-investment-grade corporations. The funds’ yield changes periodically (often monthly) to reflect adjustments in the general direction of interest rates.
Some bank loan mutual funds use internal pricing to estimate a security’s price based on numerous factors such as market conditions, liquidity, and prices provided by an independent pricing service. But buyer beware. According to an unidentified mutual fund manager cited in the November 2, 1999 issue of Smart Money, incidents of internally priced mutual funds listing some of their holdings at or near par, while the secondary market may trade an identical loan with significant discounts to par, exist. Managers of bank loan funds that rely on internal estimates contend that the secondary market is unreliable and is not privy to all information. This is the same unreliable place they would presumably sell these loans, if the fund needed to raise cash.
It should not be surprising that among the bank loan funds in Morningstar’s database, funds using internal valuations have outperformed those using third party pricing services. It is comforting to know that the current trend among these types of funds is towards using independent pricing services.
Mutual funds are permitted to invest in private placements and restricted securities. When investing in these types of securities, the fund relies on director-approved internal procedures for determining fair value when calculating an untraded security’s price. While private equity is certainly appropriate for most wealthy investors, a mutual fund offering daily redemptions is an awful vehicle for these types of investments.
Take the case of the now defunct IAI Value fund that held large positions in venture capital companies. During the first half of 1999, the fund appreciated approximately 19%, helped by two single-day jumps of 26% and 9% due to repricing private securities. However, on July 2, a positive day for the stock market, the fund dropped nearly 18% after it repriced an illiquid security. Even though the fund’s year-to-date return was flat through July 2, it was listed in most investment publications as a top performing mutual fund for the first half of 1999. Devaluing the portfolio one day after the mid-year performance measurement does not look like a coincidence.
Fair value pricing is the most appropriate technique for assessing a security’s value at any point. Unfortunately the quality of internal estimates varies. This is like letting the fox guard the henhouse. Your job as a shareholder, and ours as investment advisers, is to find an honorable fox.
