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Illiquid Securities Could Bite Mutual Fund Shareholders In The Rear

Increasingly mutual funds are buying into startups before they are public. That sounds great as you read about the valuations afforded non-traded startups. But look at the 2000 tech stock bubble, startups don’t always work out as planned. There has been a series of articles lately spattered across The Wall Street Journal, the New York Times, and Forbes discussing the issue of mutual funds and illiquid securities. It isn’t that this is a huge problem, but it’s one that’s worth understanding because it could have a notable impact on you if you happen to own a fund like , say, the Fidelity Contrafund Fund (MUTF: FCNTX ). How much is Airbnb worth? Around the middle of 2015 , Airbnb raised $1.5 billion worth of money by selling non-public shares. That gave the company a valuation of roughly $25.5 billion. Just for reference, Marriott International’s market cap is around $20 billion. Airbnb is a hot tech startup that helps people rent out their guest rooms over the internet. (Marriott is just a lowly public company that’s been doing the whole hotel thing for decades.) Airbnb is such a hot investment because it’s part of the “sharing economy” theme that’s big right now, including names like Uber. Uber is pretty much an online taxi service that allows every day folks to hire themselves out for rides. These are exciting ideas, to be sure, though I’m not a big fan myself. The idea of having strangers stay in my home or of staying in a stranger’s home doesn’t appeal to me. I’ll just pay for a room at a hotel, thanks. But the sharing society theme is really changing the world as we know it. Uber, for example, has prompted taxi drivers around the world to revolt . (And why not, taxi drivers generally have to go through hoops to get their hack licenses, anyone with a car and an Internet connection could potentially become an Uber driver.) But here’s the thing, Uber and Airbnb are private companies. Mom and pop investors can’t buy into them. But as the Airbnb example above shows, sophisticated and wealthy investors can and do. The list of well-heeled investors looking to get in on the next big thing before it goes public, however, is increasingly including mutual funds. The kind of funds that mom and pop investors actually own. That’s some list Take, for example, the Fidelity Contrafund. A quick look at the fund’s June 2015 semi-annual report shows that it’s invested in Airbnb and Uber. But that’s not the end of the list, it’s also invested in 23andme, Blue Apron, Dropbox, and Pinterest, among others. If you’ve never heard of some of these companies don’t feel bad, they are private placement darlings. But if you own Contrafund, you own a tiny slice of these startups. To be fair, they are just a small portion of Contrafund’s portfolio, but I’m not sure that these are the types of companies investors were thinking about when they gave Fidelity Contrafund their hard-earned money to invest. Contrafund, by the way, is hardly alone. For example, the T. Rowe Price Media & Telecommunications Fund (MUTF: PRMTX ) also owned Uber, Dropbox, and Airbnb, among many other private placements at the mid-point of the year . (Just to be clear, I’m not sure Uber or Airbnb count as media or telecom, and I’ll give a leery pass on Dropbox.) Forbes , meanwhile, recently highlighted the Hartford Growth Opportunities Fund (MUTF: HGOIX ) as having as much as 6% of assets in such investments with the Davis Global Fund (MUTF: DGFYX ) at 4%, those are getting to notable numbers percentage wise. And, obviously, This isn’t unique to one fund sponsor or one fund. So my first big concern is really about fund companies living up to their fiduciary duty. Are these the types of investments that should be in a portfolio meant for small investors? You could argue that the funds are providing access to an area from which investors would be otherwise excluded. Moreover, compared to the total portfolio, these investments are relatively small and could have a big payoff. These are true statements and I can see the validity of the arguments. But I remember how shocking it was to watch the tech bubble implode. It was exactly these types of companies that did the imploding once they came public. Is that risk reward tradeoff a good one for a retiree? I’m not sure it is. And if the excitement fades before these private placements list on a public exchange, these investments could turn sour and leave the funds that own them with no way out. Is that a real number? So the appropriateness of private placements in mutual funds is my first concern. But that leads to other issues. For example, it can be hard, if not contractually impossible, to sell private placements since there’s no public market. That means these are illiquid securities that could weigh down the fund in a bear market. The manager will have no choice but to sell more liquid, and potentially better, companies to meet redemptions if investors start pulling money out of the fund. That’s true even if the private companies are still doing OK operationally. And valuations are tricky, too. To give you an example, in PRMTX’s June semi-annual report it’s investment in Airbnb is listed as worth twice what it was purchased for in April of 2014. But there’s no public market so it basically had to make that number up. That’s why there’s a little number 3 footnote next to the position. That footnote tells you that its a level 3 security for valuation purposes. Note 2 to the semi-annual report explains that level 3 prices are based on “unobservable inputs.” (If that wording isn’t ominous, I don’t know what is.) In other words, T. Rowe Price didn’t have a whole lot to go on when assigning Airbnb and its other private placements a valuation. I’m going to believe that they did the best they could to come up with a reasonable valuation, but there’s a problem here. A recent Wall Street Journal article listed the per share price that was used for Uber at four different mutual funds. The difference between the highest and lowest valuations varied by nearly $7 a share. The low end was Contrafund at $33.32 a share. The high end was the BlackRock Global Allocation Fund (MUTF: MDLOX ) at $40.02 a share. On an absolute dollar basis that doesn’t seem so bad, but it’s a strikingly large 20% difference. Interestingly, the Vanguard U.S. Growth Fund (MUTF: VWUSX ) was toward the high-end at $39.64. (Yes, even Vanguard is doing it!) Now here’s an awkward questions that you can’t help but ask: Are some fund families inflating the valuation of private placement investments to boost performance? I don’t want to believe that’s true, but a 20% difference is pretty large. How could these supposedly smart people be so far apart? You have to admit that there’s a lot of temptation there, even if it turns out that everything is on the up and up. Knowing is half the battle This isn’t a reason to sell all your mutual funds. But it is a warning that you should take a moment to review the list of securities that your mutual funds own. You might be surprised at what you find. And while the exposure to these securities might seem small today, don’t underestimate the risk this could pose to the fund and your wealth. That’s particularly true if the impressive valuations that private placements are being afforded today turn out to be nothing more than wishful thinking-just like the Internet darlings that fell of a cliff in the tech crash.

Lipper Closed-End Fund Summary: October 2015

By Tom Roseen For the first month in seven equity and fixed income CEFs posted plus-side performance on average on both a NAV basis (+5.97% and +1.07%, respectively for October) and market basis (+7.50% and +3.41%). Year to date equity CEFs remained in the red for the fourth straight month, down 4.41%, while fixed income CEFs moved more solidly into the black, returning 1.54% on average on a NAV basis for the same period. For the month many of the major broad-based indices chalked up their best one-month return since October 2011, with the Dow Jones Industrial Average Price Only Index and the S&P 500 Composite Price Only Index returning 8.47% and 8.30%, respectively. Beleaguered Shanghai Price Only Composite and Xetra DAX posted a couple of the strongest returns in the global markets, returning 11.50% and 11.15%, respectively, for October as investors cheered easy-money news from both the Peoples Bank of China (PBOC) and the European Central Bank (ECB). Despite a weaker-than-expected jobs report at the beginning of the month, mixed economic data throughout the month, and a roller-coaster ride of corporate earnings reports, volatility-as measured by the CBOE Volatility Index (VIX)-fell 38% over the month to 15, remaining below the long-term average of 20. Investors appeared to shrug off a disappointing nonfarm payrolls report that showed the U.S. had added a lower-than-expected 142,000 jobs for September-below the consensus-expected 200,000-as investors perhaps realized the Federal Open Market Committee was probably not going to raise interest rates this year. As commodity prices rallied mid-month, the S&P 500 posted is strongest weekly gain for 2015. And while the Fed minutes’ discussing global risks kept the hawks in check, many felt the downside risk was on the mend. Ignoring a slight decline in industrial production for September, consumer sentiment rose in October for the first month in four. A surprise cut in interest rates by the PBOC, better-than expected earnings reports from a few heavyweight tech firms (Amazon (NASDAQ: AMZN ), Microsoft (NASDAQ: MSFT ), and Alphabet (NASDAQ: GOOG )), and hints from the ECB that further easing might be in the cards pushed stocks to a fourth consecutive week of plus-side performance and sent investors into risker assets for the month and out of some recently popular safe-haven plays. Battered energy stocks got a shot in the arm with the rise in commodity prices and on news the central bank in the second largest economy in the world had cut interest rates, sending Lipper’s domestic equity CEFs macro-group (+6.48%) to the top of the equity CEFs universe for the first month since August 2014. World equity CEFs (+5.46%) and mixed-asset CEFs (+5.03%) also fared well during the month. Treasury yields rose at all maturity levels along the curve after the Fed left the door open for possible rate increases later this year, with the largest increase witnessed in the six-month yield and the five-year yield, 15 bps each to 0.23% and 1.52%, respectively. For the first month in four all three fixed income CEF macro-groups posted plus-side returns, with world bond CEFs (+3.29%) leading the way, followed by domestic taxable bond CEFs (+1.19%) and municipal bond CEFs (+0.68%) as investors put some risk back in their portfolios. For October the median discount of all CEFs narrowed 157 bps to 9.58%-slightly worse than the 12-month moving average discount (9.50%). Equity CEFs’ median discount narrowed 91 bps to 11.29%, while fixed income CEFs’ median discount narrowed 160 bps to 8.41%. For the month 82% of all funds’ discounts or premiums improved, while 16% worsened.

S&P 500 Posts 3rd Best October Returns In 25 Years

After losing -8.35% over the prior 2 months, the S&P 500 was up +8.44% in October. Abnormally high monthly returns like this are uncommon by historical standards. The stock market in 2015 continues to illustrate a volatile and highly unstable investment environment. We have often heard investors refer to October as being one of the worst months to invest in the stock market. To the degree that we have even witnessed investors hastily move their investments to cash. Perhaps this lies in some deeply rooted market fears that can be traced back to Black Monday , when on October 19th, 1987 the U.S. stock markets lost nearly -22% in a single day of trading. Whatever the cause for trepidation may be, the reality is that over the past 25 years October has actually been one of the best months to be an investor in domestic equities. After two consecutive months of negative returns for the S&P 500, investors entered October 2015 spooked by such technical omens as a break in the 200 day moving average, a death cross , and the Hindenburg Omen , among others. And yet, after all of the technical damage that had been wrought in recent weeks the S&P 500 managed to shock us all by turning in the best October return since 2011, up +8.44% for the period. While that last statistic may not sound overwhelmingly impressive, one must further consider the context. That unexpected +8.44% monthly return was actually the third best October return in the past 25 years! Perhaps even more incredulous is the fact that that was actually the 7th best return generated in any month over the past 25 years period (including the “go-go” markets of the 90’s)! In other words, out of the past 397 months of S&P 500 returns, last month’s return came in 7th. And let’s be blunt, no one saw it coming. In October of 2011, the S&P 500 generated the highest return of any month over the past 25 years, up +10.93%. This came after 5 consecutive monthly losses over which the S&P 500 suffered a cumulative decline of -16.26%. Losses over this period were exacerbated by an August S&P downgrade of U.S. long-term debt from AAA to AA and growing fears that the Euro may break up, all of which led to capitulation by worrisome market participants. As is the case in most instances, the markets overreacted to the downside and rebounded with strength shortly thereafter. In October of 2002, the S&P 500 generated the 2nd highest October return over the past 25 years, up +8.80%. This came at the height of the bursting of the Tech Bubble, where over the prior five month period the S&P 500 experienced an outsized cumulative loss of over -28%. So here again, we witnessed capitulation followed by a strong rebound. Even coming out of the Great Recession, when in early March of 2009 we finally found our bottom, the S&P 500 generated a monthly return of +8.76%. However, this strong return to the upside only came after the markets had lost a gut wrenching -41.83% over the prior 6 month period. So forgive us if we find it somewhat peculiar that the S&P 500 was up over 8% last month. In nearly every instance in which returns of this magnitude have been generated in a single month over the past 25 years, they have come only after the markets had suffered significant losses. While we recognize losses of any size may be difficult to bear, a loss of slightly more than 8% over a two month period is exceedingly commonplace in the stock market. What is uncommon are returns north of 8% in a single month without coming after significant losses. In 2002 when October returns were this strong, the S&P 500 still finished down -22.10% for the year. In October of 2011, when the S&P 500 posted it’s strongest monthly return over the last 25 years, the S&P 500 finished up a modest +2.11% (all of which was attributable to dividends, without them the return was actually 0.0%). Where we end up for 2015 is really anyone’s best guess, but after taking a look at monthly returns over the past 25 years, it should be clear to see that volatility has increased and the markets appear undecided for the time being as to whether our next leg will be up or down. It should also be clear that listening to the noise that is so widely disseminated in our industry, should largely be ignored. What is more important is that investors follow an investment discipline devoid of emotional influence. With that said, we would be remiss if we did not impart a word of caution regarding our current investment environment. One should be weary of market head-fakes , as the markets in 2015 have grown increasingly prone to lead investors in one direction, only to quickly reverse course. Adding new monies into equities at this time may very well prove to be an exercise and lesson in chasing returns. For tactical investment managers, employing an asset rotation based investment approach, whipsawing markets such as we have seen thus far in 2015 can prove to be challenging, as underlying trends become less stable. However, if executed properly the purpose of reducing volatility in returns and achieving low correlations to both the equity and bond markets should be evident. For those unfamiliar with tactical portfolio management, you may refer to our previously published article on SeekingAlpha, How To Beat The Market With Tactical Asset Rotation or our recently published book by Wiley & Sons, “Asset Rotation” . In each we illustrate a rudimentary approach to tactical portfolio management and provide a root foundation for understanding the benefits of this type of investment philosophy. Lastly, since we have attached a table with monthly returns on the S&P 500 for reference pertaining to this article, there are a couple ancillary points we will leave you with that may surprise you: Over the past 25 years, October has generated a negative monthly return only 7 times (tied for third best). 3 out of the 7 best monthly returns over the past 25 years have come in October. Surprisingly, July and September posted monthly losses in 12 out of the past 25 years (tied for the worst month for investors over the period). Never underestimate the power of the jolly fat man… December has posted a negative rate of return in only 4 out of the past 25 years (by the far the best month for investors over the past 25 years). (click to enlarge)