The danger of reaching for yield

The closing of the Third Avenue Focused Credit Fund holds several lessons for financial advisers, their clients and industry regulators.

In a surprise move, management announced Dec. 9 that it was liquidating the fund and freezing redemptions so it didn’t have to sell assets at fire-sale prices. Shareholders may not be able to get their hands on their money for months.

Third Avenue’s fund had an unusually high exposure to high-yield corporate debt, which no doubt accounted for its poor performance and heavy redemptions this year.

At the time of its shutdown, the fund had $788.5 million in assets, down from $3.5 billion in June of last year, according to Bloomberg. The fund was down 27% year-to-date.

As senior columnist Jeff Benjamin reported, the Third Avenue fund was an outlier, with an estimated 28% allocation to bonds that were rated triple-C or lower. That’s nearly three times the average allocation to low-quality debt at other similar funds.

READ THE PROSPECTUS

In short, the fund was chasing yield. The Wall Street Journal reported that more than 50% of the bonds it held paid annual coupons of more than 10%; meanwhile, the average high-yield fund had less than 5% of its assets in that category.

Lesson 1: In this era of low interest rates, there are likely many investors who have strayed outside their comfort zone and similarly reached for yield. This should serve as a reminder to these investors — and their advisers — that there is a trade-off for adding another percentage point or two to one’s investment returns. Sometimes it means risking principal that investors can’t afford to lose.

Did investors know what they were getting into when they bought into this fund? Did they know that by design the fund was looking for distressed debt? If they read the fund prospectus, they probably did, but how many investors — or more importantly, how many of their advisers — actually took the time to read it?

Mr. Benjamin checked in with advisers, and some admitted they don’t bother reading these important documents. “I don’t read them and I don’t know anyone who does read them,” said one veteran adviser, who complained that prospectuses are written to protect the fund company instead of the shareholder. “It’s a legalese joke,” he said.

Another adviser agreed, and said he can find the condensed information he needs about a fund from Morningstar or a similar service.

Lesson 2: Prospectuses may not be scintillating, but advisers need to read them if they are recommending funds to their clients. It is part of their due diligence and what in-vestors expect of them. It is also the only way to be sure they understand the downside of the fund’s strategy. As for their being dense and hard to understand, one adviser said you can learn what to look for in prospectuses without having to read them in their entirety. “Even skimming a prospectus is better than not reading it all,” he said.

FROZEN REDEMPTIONS

Perhaps the most disturbing part of Third Avenue’s announcement was that it froze redemptions, taking even some seasoned market watchers by surprise. While the move was unusual, some said it made sense because investors eventually would recover more money this way. That didn’t stop the Securities Division in Massachusetts from opening an investigation into both the closing of the fund and the liquidation plan. A week after Third Avenue suspended redemptions, the SEC approved its liquidation plan.

Lesson 3: One reason many investors put money into mutual funds is because they are liquid: You can trade in your shares and get your money back. At least that’s what most investors thought. The fact that Third Avenue put its plan in place and then asked for SEC approval is problematic. The bottom line is there needs to be better disclosure to investors that this can happen. Since the financial crisis, the SEC has been working on ways to ensure fund companies can meet investor requests for their funds without having to resort to extraordinary means. It is clear from this episode that there is still work that needs to be done.