Goofy, Esoteric Securities are a Red Flag

Financial entertainment got a holiday gift with the fiasco surrounding the Third Avenue Focused Credit Fund.  The fund halted withdrawals amid investor outflows which was “shocking” according to Barron’s.  The sharks are circling as the media has had easy filler content – “Worried About Your High-Yield Bond Fund?” and so on.  The thing is, the Third Avenue Focused Credit Fund was not a high yield bond fund and even cursory due diligence would have revealed this.  That anyone was caught off-guard by this development should be the real story here.

I still have my notes from my due diligence on the fund in January of 2013.  The number one thing that stands out is that it is/was a DISTRESSED CREDIT fund.  This means that it invested in illiquid and sometimes non-performing stuff.  I say stuff because they didn’t hold just bonds.  The fund also held equities and other securities from restructuring events (like when a company goes bankrupt and the bonds might be exchanged for equity in the new company, for example).  Third Avenue was not shy about any of this.  They were very straightforward about the large cash position needed to maintain the 40 act mutual fund structure.  That cash was there because the driver of returns was really goofy, esoteric stuff like freaking Lehman Brothers SIPA claims.  When you see Lehman Brothers as two of the top ten holdings (this was in 2013 during my initial review of the fund) in a fund you’re doing due diligence on, that is a good indicator of what you’re getting in to.  If you don’t know what the hell a SIPA claim is, you should not be investing in them.  I get the feeling, however, that brokers saw an 8% yield and $2,500 minimum investment and took the opportunity to make some sales.  Clients jumped in with both feet because they think their ‘investment guy’ did the due diligence.  This is a shame because the red flags were all right there.  This wasn’t some hidden line on page 137 of a prospectus.  On the fund’s March 2015 two-page fact-sheet you would see:  Restructuring securities made up 13.9% of the fund, Equities made up 14.2% of the fund, High-yield securities with a credit spread of over 1000 basis points made up 33.5% of the fund.  This was obviously not the run of the mill high-yield bond fund.  At the very least, this should have spurred some additional questions.

On the heels of a devastating financial crisis where illiquid assets were poison, this fund amassed almost $2.5 Billion in assets.  Chasing returns/yield can be devastating.  This is a case where an investment you didn’t make would have turned out better than getting sold a product.  It’s ok to say no to your ‘investment guy’ or ask to see the due diligence.