In bull markets, mutual fund managers often reap too much cash to invest in an overvalued market. However, bear markets yield a different set of problems.

In a falling market, a fund's securities that appear to be liquid suddenly may have no market. If a client wants to cash out of a fund, there's a risk that a fund manager could be unable to find enough buyers of those securities to meet redemptions. Thus, mutual funds may suddenly be a lot riskier than many originally thought, and this is important to continually keep in mind.

Take the case of the Firsthand Technology Value Fund. The investment company earlier this year mailed shareholders a supplement to its prospectus, stating that its fund's illiquid securities have occasionally been exceeding 40% of its net assets. It attributed the illiquidity to two privately held solar technology companies in which it had placed venture capital. The fund's venture capital investments had enjoyed better relative performance than its investments in public companies over the past several quarters. But the fund had not disposed of those illiquid securities, and at the same time, it had endured shareholder redemptions, leaving a greater proportion of illiquid holdings.

The Securities and Exchange Commission considers a security to be illiquid if it cannot be disposed of within seven days in the ordinary course of business at approximately the same price the fund has valued it. The commission requires that funds state what they invest in and value the investments.

"Illiquid securities take longer to sell, and may not necessarily be sold at the fund's then-carrying value," says the Firsthand Technology Value supplement.

Firsthand may be just the tip of the iceberg. Open-end mutual funds can invest in a limited amount of illiquid securities, too. The problem: In a declining market, they risk not being able to profitably sell those securities.

In 1992, the SEC raised the amount of "illiquid" securities that open-end management investment companies can hold to 15% of net asset value from 10%. The reason was to provide small businesses better access to capital markets. Since then, according to published reports, mutual funds have moved into some less liquid areas such as private equity, venture capital investments and PIPEs (private investments in public equity).

As a result, a financial advisor should not be surprised if some client funds have too much in illiquid assets. Despite the lack of hard data on mutual fund illiquidity, many say that mutual funds are probably more liquid now than they were during the credit crunch last year.  

Mutual funds represented 7.77% of the buyers in the illiquid PIPE market in 2008 at their peak, up from 5.28% in 2007, says Brian Overstreet, president of Sagient Research Systems Inc. in San Diego. But in June of this year, he says, the company's "PlacementTracker" research service found that only 2.8% of PIPE dollars were raised from mutual funds. Now most of the PIPEs are being bought by private equity and venture capital, and hedge fund and mutual fund investment in them have decreased substantially.

Still, mutual fund illiquidity should continue to be monitored. In 2008, the liquidity crisis in the bond market took center stage.
"There were some bond funds that bought certain types of bonds that the market vanished on," reflects Mari Adam, a fee-only advisor in Boca Raton, Fla.