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."