Shareholders in the IAI Value fund recently got a personal lesson in the phrase “Here today, gone tomorrow.”
The Minneapolis-based small-cap fund was up roughly 19 percent for the first half of the year. Two days into the second half, the profit was gone, almost all of it wiped out July 2 when the fund fell from $12.46 per share to $10.26.
IAI called the drop a “repricing,” fundspeak for “Oops.”
So while shareholders were treated to paperwork showing a solid first half, with the fund ranked near the top of 1,200 growth funds tracked by Lipper Inc., IAI Value was barking like a big dog. One week after the quarter ended, the fund was among the 10 worst growth funds in Lipper’s year-to-date database.
While the media passed off the decline as nothing more than a a fund having a bad week, the truth is that what happened to IAI could happen (although to a lesser extent) to many other funds.
IAI has acknowledged its Value fund blew up due to private placements, illiquid investments in companies that aren’t public. Beyond that, no one there was talking last week.
Nearly half of the fund’s $12 million was in these murky investments, which so dramatically add to volatility that many observers believe IAI Value was closed to new accounts in 1998 in order to avoid potential lawsuits from investors who get whipsawed in moves like the one July 2.
Buying private stocks is an accepted form of small-cap investing, allowed by IAI’s prospectus and federal regulations.
While few firms trade as heavily in private placements as IAI, pricing mishaps can happen in any fund buying thinly traded assets, from micro-cap stocks to small international issues, emerging markets investments and even municipal bonds.
In addition, the IAI Value situation also shows that a fund’s share price can, at times, be more fiction than fact.
Net asset value, a fund’s per-share price, is calculated at the end of each day based on the current value of a fund’s holdings. Loosely speaking, accountants tally the total market value of a fund’s securities, then divide by the number of shares to set a price. Any trades made during the day are executed at this end-of-day value.
But the real accuracy of the share price depends on how a fund values securities, especially those that don’t trade every day. When it comes to private placements and lightly traded stocks, it is usually the fund’s directors who are charged with calculating “fair value in good faith.”
Many times, illiquid securities are “flat-lined,” treated as if the price has no daily change. Periodically, based on new information from the sale of more private stock or other data, the fund adjusts its estimate of the private stock’s real value.
Sometimes, notably when private companies go public with a splash, a fund skyrockets when private stocks are revalued. IAI Value, for example, was up 26 percent one day in January and 9 percent in a single day in April, thanks to events like that.
Aside from those two days, the fund muddled along until the July blowup, which looks particularly bad given the timing. On the surface, it appears management may have been “window-dressing,” making everything look good for midyear reports and company statements.
IAI’s valuation problem is unusual, but in no way unique. Small pricing adjustments of 1 to 3 percent are not uncommon.
Public stocks that don’t trade for days at a time are valued at the average of bid and ask prices, rather than the last trade price. From an accounting standpoint, this makes the stock more volatile. Bid and ask average pricing also applies to muni bonds.
For investors, there is little to do beyond finding out if a fund trades in illiquid securities. SEC rules limit funds to putting no more than 15 percent of their portfolios into private placements, but through such variables as appreciation or portfolio shrinkage, that percentage can grow over time, as happened with IAI.
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Charles A. Jaffe is mutual funds columnist at The Boston Globe. He can be reached at the Boston Globe, Box 2378, Boston, Mass. 02107-2378 or by e-mail at jaffe@globe.com.
