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.

Some conservative investors with money in bond funds may not understand some securities in their portfolios, she says. For example, some bonds funds may own credit-default swaps or use heavy leverage. Adam says she's less worried about stocks, which are more heavily traded, than bonds.

Douglas Miles, the CEO of Globalprivatequity.com Inc. (GPE), an independent valuation company in Princeton, N.J., says top-rated overnight repurchase agreements in asset-backed securities have virtually dried up. Since last year's failure of Lehman Holdings Inc., this $1.5 trillion overnight market has probably already moved into a wide range of other less-liquid, shorter-term investments, he warns.

Because of the ever-present liquidity issues faced by mutual funds, it's important for financial advisors to keep close tabs on their clients' funds. Advisors may be able to check a mutual fund's illiquidity, as a percentage of net assets, by looking at the most recent financial statement or prospectus or by calling the fund company directly and asking for it, says Erik Hotmire, spokesman for the SEC. While the percentage of illiquid securities does not have to be shown on financial statements, some funds identify it anyway.

During fund examinations, the SEC may look at these illiquidity percentages. "If it exceeds 15%, we stress the need for the fund to reduce the percentage," Hotmire says. But he also says the SEC doesn't want to force the fund to sell a holding in an unfavorable market either.

Although certain complex illiquid deals may mean discounted prices for a fund, they could also spell added legal fees and raise conflicts of interest. Plus, judging whether a security is illiquid and then finding a value for it may be a process that's a little too subjective, some argue.

Such valuation will likely become a bigger point of heated discussion with the impending regulation of over-the-counter derivatives, says Susan Mangiero, president of Pension Governance Inc. in Trumbull, Conn. Mutual funds, she predicts, likely will get very involved.

Already, the SEC has fined at least two firms, Evergreen Investment Management Company LLC and Van Wagoner Capital Management Inc., for allegedly misstating valuations. The SEC said in its case against Evergreen, announced June 8, that the company's Ultra Short Opportunities Fund consistently ranked as a top performer in 2007 and 2008-but would have ranked near the bottom of its category had it been valued properly.

The bottom line: It's important to look for signs in portfolio documents-in the periodic review or in the statement of additional information. A fund with too much in illiquid assets may be an unsuitable investment for some clients.

Most of these ratios showing the proportion of illiquid assets, Mangiero observes, are only at a particular point in time. "If I'm a financial advisor and looking at point-in-time ratios, I wouldn't come away saying, 'Oh boy, am I relieved!' I'd still want to understand, "Does the mutual fund have a risk manager? Does the mutual fund have specific policies on how they deal with possible write-downs? If there's a private equity or venture capital position and it looks like the company is struggling, do they write that down right away and how do they write it down?

"Are they using an independent party to come in and value those hard-to-value instruments? If not, I would construe that as a red flag. If they're doing evaluations internally with no ongoing oversight of the valuations, as a financial advisor for my clients, I'd be a little nervous."

On the other hand, the nailed-down illiquidity ratio may not present the complete picture either. The definition of an illiquid security may change over market cycles. Take credit default swaps. Two years ago, these would have been considered liquid. Today, they're not so liquid.

The rules for valuating illiquid assets can also be manipulated to present a fund in a better light, says Miles of Global Private Equity. Or, like anyone else, a fund group may simply give the valuation of its securities lower priority while they're dealing with other more pressing demands.

The SEC says that when market quotations are not readily available, funds must value portfolio securities and all other assets by using their fair value as determined in good faith by the fund's board of directors. The Financial Accounting Standards Board's FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP) and expands disclosures about fair value measurements.

Miles cites other details to examine. Is a fund's valuation policy approved by the board of directors or by the chief investment officer of the mutual fund group that sponsors the fund?

"Who are the providers of data points?" he asks, stressing that you don't want it to be a summer intern who is simply doing the bidding of the fund. "How many [data points] are they using? Do they use methods for valuation that your public accountants approve of?"

If a manager owns several shares of Intel, you know how he or she can get out of them. But if the manager owns several illiquid IOUs from a foreign country denominated in dollars, the bid-offer spread can vary by 10% to 15%, he says.

Under that circumstance, the bid that should be reported, he emphasizes, is the worst-case bid. Otherwise, the investor isn't getting a true picture.

Karen Dolan, an analyst at research company Morningstar, recently reported that her firm will flag mutual funds facing outsized pressure from outflows and ask about liquidity in management interviews. "Some of the biggest problems," she says, "have come from funds that were seeing investors flee at a faster clip than they could sell securities to meet those redemptions."