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."