Mutual Fund Valuations Mutual Fund Valuations
For example, a small stock might trade "by appointment" because it is held a few large investors and company insiders. This would be reflected in the "bid/ask" spread of the stock. Take a stock with a "bid price", the price that potential buyers are willing to pay, of $6 and an "ask" price, the price that sellers want to receive, of $8. There is a large gap of $2 between the two price which is the "bid/ask spread". Which market price should the mutual fund company use for valuations? Clearly, those investors selling fund units would want the higher "ask" price of $8 and the investors buying fund units would want the lower "bid" price of $6. The mutual fund companies usually take the "mid market" price, the price half way between the bid and ask price. In our example, this would be $7, $1 less than the "ask" price but $1 higher than the bid price.
The $1 of our example does not seem like a huge issue, but consider if the fund held 1,000,000 shares of this company and it was almost 10% of the total mutual fund assets of $80,000,000. At the bid price of $6, the whole position would be worth $6,000,000 and at $8 it would be worth $8,000,000, a difference of $2,000,000! Using the mid-market price of $7,000,000 still makes a difference of $1,000,000 from the bid and ask prices. On a fund of $80,000,000 the $1,000,000 difference is 1.25% of fund assets. The $2,000,000 difference between the bid and ask price represents is 2.5% of fund assets. These amount might seem small, but it is in the same range as the annual fee charged by the fund management company to the fund.
The example above applies to a stock traded on the public markets. Valuations become even more imprecise for less liquid assets. A good example of this would be high yield or "junk bonds" which trade "over-the-counter" (OTC) instead of an organized exchange. When there is uncertainty about the issuer, it might be impossible to get a bid for this type of bond. This type of "price gapping" results because investment dealers don't want to have a bond that might default on their books and potential buyers are holding off until the situation becomes more clear. A major part of the Drexel Burnham scandal in the 1980s involved "junk bond" price manipulation by Drexel and their clients, trying to protect their junk bond inventories and positions by "rigging" the prices of the trades that they made.
Illiquid assets such as mortgages and real estate seldom trade. This makes their pricing a matter of opinion. Many commercial mortgages were valued at high levels during the early 1990s, even though many of the borrowers could not make payment on these securities after the real estate collapse. Real estate poses the same problem, although professional appraisers are used to value property investments. A good example would be the First Canadian Place office building in Toronto. At the time of the issue of bonds secured by this building in 1988, it was appraised at nearly $1 billion. A few years later, after the collapse of the Reichman's Olympia & York real estate company in the early 1990s, the same building was appraised at $400 million. The building had not changed; however, sentiment about the commercial real estate market had changed.
The inability to easily value or liquidate these type of investments has caused regulators to limit, in Canada, illiquid investments to 10% of a mutual fund's assets. As we have seen, however, even marketable securities can be hard to value and may not be able to be liquidated when necessary. When it comes to investments, liquidity risk is having your money available when you need it.
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