Tuesday, March 24, 2015

A Warning That’s Not Required: Private Companies in Mutual Funds

A Warning That’s Not Required:  Private Companies in Mutual Funds

The New York Times made a significant mistake yesterday when it ran a story raising concerns about the growing amount of private venture-backed companies held by mutual funds.[1]  The headline, “Americans’ Retirement Funds Increasingly Contain Tech Start-Up Stocks” probably made more than a few retail investors nervous about their 401(K) or brokerage account.  While the story makes a series of valid points, it reaches a completely incorrect conclusion.

It is true that mutual funds are increasing their purchases of stock in non-public companies rather than waiting for those companies to go public.  It is also true that valuations for these companies (e.g., Uber, Airbnb, and Pinterest) have risen significantly, and some of them may turn out to be grossly overvalued.  It is also true that financiers and investors have given these companies a catchy name, “unicorns”, because of their magical ability to attract capital at ever-increasing prices.  Private stocks carry more risk than public securities because there is no liquid market to sell shares.  As the Times points out, the markets that exist to buy and sell private securities are fragile and tend to shut down when bad things happen to the companies.

However, this isn’t a major problem brewing inside mutual portfolios.  While I didn’t conduct an exhaustive survey, I did pull the annual reports for two funds cited by David Gelles and Conor Dougherty as big players in illiquid securities.  According the Times’ reporting, the Fidelity Contra Fund has about $400 million invested in Uber, Airbnb, and Pinterest, and according to the fund’s annual report has a total of $1.5 billion in highly illiquid securities (known as Level-3).  It sounds like a lot of exposure until you realize that the Contra Fund has $110 billion in assets.  That comes out to 1.3% of the fund’s assets spread across many individual holdings.

T. Rowe Price’s New Horizons Fund is also a large participant according to the Times.     According to their annual report, it holds $500 million worth of illiquid securities in a fund valued at $15.4 billion (3.2%).   There are a lot of things that might keep an investor awake at night, but the exposure of mutual funds to private companies isn’t one of them.

In fact, the real question is why the mutual funds are bothering at all.  Let’s assume that Contra Fund’s $400 million investment in the three unicorns doubled in a year.  The fund would rise by an additional 0.3% (before fees), a nice little return for investors but certainly not a home run.  My guess is that these unicorn investments are more about allowing mutual fund portfolio managers to be players along the fringes of venture capital rather than a strategy to help out investors.

[1] http://www.nytimes.com/2015/03/23/business/dealbook/tech-money-sends-funds-on-the-hunt-for-unicorns.html?src=me&_r=0

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