What The High Profile Mutual Fund Freeze Means For You

Written by John Osbon on December 16, 2015

When the news broke that Third Avenue Management suspended redemptions in its junk bond mutual fund, it raised eyebrows and questions. Here’s a quick look at what happened and why it matters.

What happened?

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  1. Third Avenue’s Focused Credit Fund sought to deliver a robust yield to investors by holding relatively high risk corporate (junk) bonds. Unfortunately the fund’s managers chose companies and sectors that turned out to be far junkier than typical junk, including lots of energy companies unable to make interest payments.
  2. As prices fell, investors wanted out. Redemptions exceeded available cash and the fund had to sell its “better” junk to pay investors, leaving the worst of the worst. The remaining bonds were impossible to sell at favorable prices.
  3. Then, remarkably, management solved this problem by ending individual redemptions! Holdings will be sold off slowly over time, with proceeds distributed, someday, to shareholders. If you own shares, you’ll likely have to wait many months before you see whatever disappointing payout you’re due.

Does this signal a collapse in junk bonds?

Anything is possible, but this fund held such a rotten mess of bonds, it’s not likely to foretell the future for the asset class in general. A more valid takeaway here is the peril of active management – trusting a fund manager’s hunches and guesses about how specific companies and sectors will fare in an unknowable future. That’s why we exclusively utilize index ETFs to access different asset classes, including junk bonds. Index tracking means instant diversification across the asset class, every investor’s best protection against uncertainty.

Why is this redemption freeze so noteworthy?

Disallowing the selling of shares is familiar to hedge fund investors, where such a limitation is called a gate, but for mutual funds, this kind of maneuver is exotic, and not in a good way. Mutual funds are thought of as ready-made for everyday investors; still, managers can pull the plug on redemptions without warning. We expect thousands of investors were blindsided by Third Avenue’s ugly move.

Fortunately it doesn’t happen often, but the fact that it can and in this case did, is a cautionary tale and one of several reasons why we eschew mutual funds completely. Also on the list: allowing trades only at 4 pm, no matter how volatile markets may be during the course of the day; and sticking the unpaid tax bill to any individual who buys the mutual fund, no matter when in the year they buy.

What’s the alternative?

The mutual fund served a great purpose in the 20th Century, offering retail investors access to hundreds of securities with a single trade. But the investment vehicle failed to evolve with the markets and technology. That’s how the ETF emerged as such a powerful new-century alternative. The explanation for this is complex, but ultimately ETFs utilize a different structure and different redemption mechanism, which make Third Avenue style freezes impossible. Further, the ETF trades at dynamic prices all day long and minimizes capital gains tax surprises.

Knowledge is power in investing, and the Third Avenue story is one we can all learn from.

John Osbon – josbon@osboncapital.com

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