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Mutual Funds Valuation

Putting a value on a mutual funds valuation can be complicated when some securities prove to be hard to value and illiquid. After all, when it comes to investments, liquidity risk is having your money available when you need it.

Mutual Funds Valuation
Most large funds hold highly “liquid securities,” which means that the fund can raise money by selling securities at prices very close to those used for valuations. An important issue for open mutual funds valuation is the valuation of investments that are less liquid and trade infrequently.

For example, a small stock might trade “by appointment” because it is held by 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 prices, which is the “bid/ask spread”. Which market price should a company use for a mutual funds valuation? 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 one million shares of this company and it made up 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 amounts may seem small, but they’re within 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. A mutual funds valuation becomes 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 because potential buyers are holding off until the situation becomes clearer. Students of market scandals may recall an episode from the 1980s which involved the then-venerable and now extinct firm of Drexel, Burnham and Lambert. This affair 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, although professional appraisers are used to value property investments.

The inability to easily value or liquidate these types of investments has caused regulators to limit, in Canada, illiquid investments to 10% of a mutual fund’s assets.
As we have seen with mutual funds valuation, 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.