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.