Your mutual fund may be mispriced; How ‘alternative investments’ can add to valuation risk

Sept. 30, 2013, 9:47 a.m. EDT

Your mutual fund may be mispriced

How ‘alternative investments’ can add to valuation risk

By Chuck Jaffe, MarketWatch

One of the dirty little secrets of the investment industry is that on any given day, there’s a good chance that your mutual fund is mispriced.

It’s probably not off by much—tiny fractions of a penny, maybe–and the error isn’t likely to affect anyone who doesn’t sell the fund during a day when pricing is inaccurate, but every now and again, the values get way off-kilter. When that happens to funds, bad things happen to shareholders. For proof, consider a survey of fund directors just released by Deloitte, which focused on “fair-value pricing” and showed that three-quarters of fund firms changed their procedures and processes for fair-value pricing of fund investments.Under normal circumstances, this kind of esoteric back-room maneuvering is something that fund investors have no reason to worry about, but a lot of these internal controls are being changed because of the proliferation of “alternative investments” being used in traditional fund products. While the “alternative” label gets applied to a lot of different things—some of them mainstream, some illiquid and exotic—the truth is that investors should know just how much “valuation risk” they can face in a fund.

To see how bad it can get, first you must understand the pricing process and then it’s worthwhile to look at the case that is the real reason why fund directors are covering their butts and changing valuation policies.

Every day, mutual funds must “mark to market,” which effectively means putting a current value on all of the holdings in the portfolio. This allows the fund to determine their net asset value, the share price; if you sell a traditional mutual fund during the day, you will get the closing price for that day, once the fund has been marked to the market and properly valued.

In a large-cap growth fund, valuing securities is pretty simple, just use the closing price on the stock. But throw illiquid securities into a fund—from obscure stocks that have insignificant trading value to securities from foreign countries where the price and the exchange rate represent a moving target to much more—and suddenly you are aiming at a moving target or venturing into educated-guess territory.

In mid-June, the U.S. Securities and Exchange Commission settled civil charges that accused eight former directors of Morgan Keegan bond mutual funds of failing to properly supervise the portfolio managers they were supposed to be policing, allowing toxic mortgage products to be overvalued prior to the financial crisis of 2008.

Essentially, according to the SEC, the directors often allowed the portfolio managers to be involved in valuing certain mortgage-backed securities, and they kept those prices inflated even as the real world was suggesting a collapse. When the financial crisis hit, the affected Morgan Keegan funds were cut in half—losses that were exacerbated because the securities were overvalued to begin with; as a result, more than 39,000 investors across the country lost about $1.5 billion.

Morgan Keegan agreed to pay more than $200 million in penalties. The case spawned a rare action against the directors, which was settled without monetary damages, but with the promise that if any other directors screw up like this in the future, hefty fines will be involved.

That’s why directors are nervous.

According to Deloitte’s 11th annual fair value pricing survey, SEC enforcement actions were the most talked about topic among board members outside of regularly scheduled meetings. More than half of the mutual funds surveyed have changed the valuation materials—and the level of detail—given to the board.

“It’s one of those things where no news is good news, because that means the policies, procedures and controls are working,” said Paul Kraft, lead partner for Deloitte & Touche in Boston. “If you think of all of the mutual funds and all of the individual securities that get valued, it isn’t something that is likely to hurt you. But if you are buying a fund that using alternative investments, you should at least know that the directors and fund managers are thinking about it, and you should know how worried they are that something could go wrong.”

You’ll find that kind of information listed among “risk factors” in a fund’s prospectus. Nobody wants to read those, and searching for “valuation risk” could lead to dense, indecipherable jargon.

But if there’s a lot of disclosure there, the words don’t matter much; the fund is giving you the picture that it is busy protecting its backside.

Kraft noted that directors are nervous, particularly about alternative funds, largely because these issues typically advance and improve only after some snafu—like Morgan Keegan’s—results in catastrophe. “I wouldn’t say that investors should expect something to go wrong in the pricing of their fund,” said Kraft. “It’s very unlikely that you will ever see a problem that affects you.…But if you have funds that are buying alternatives or securities where these kinds of issues can come up, you at least want to know that they are worried about it so, yes, look at the prospectus.”