Hidden in plain sight: Big risks at failed Third Avenue fund were clear to some

Wed Dec 23, 2015 6:01pm EST
 
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By Tim McLaughlin, Ross Kerber and Svea Herbst-Bayliss

BOSTON (Reuters) - In the months before the blowup of Third Avenue's junk bond fund in early December, investors and financial advisors called the New York-based investment company to voice their concerns about the growing percentage of hard-to-trade, illiquid assets in the fund's portfolio.

"I would call up and they would say, 'We're under control, we have plenty of cash,'" said Richard Berse, president of Northstar Financial Advisors Inc in New Jersey. But Berse, who had as much as $2.5 million in client money in the fund, got burned. Less than a month after his last call to Third Avenue Management LLC, the $789 million Focused Credit Fund abruptly blocked investor withdrawals and announced on Dec. 9 it would liquidate the fund's assets. The extent of the losses are unclear. Brad Alford, chief investment officer of Alpha Capital Management in Atlanta, also said he told Third Avenue the fund was too volatile because it was holding too much in illiquid assets. "I just became very uncomfortable with it," said Alford, who pulled out of the fund this summer.

The biggest mutual fund blowup since the 2008 financial crisis underscores how difficult it can be to rein in a mutual fund taking outsized risks compared with its peers, even though Focused Credit officially had many overseers. The U.S. Securities and Exchange Commission, which is now investigating the fund’s meltdown, did not get involved until it was clear Third Avenue’s only recourse was to liquidate the fund, according to people familiar with the situation. Executives at Third Avenue and its parent company, Affiliated Managers Group Inc, declined to comment or did not respond to several requests to comment for this story. When compared with other junk bond funds, Focused Credit carried an elevated amount of risk. The fund disclosed, for example, that its so-called Level 3 assets, or securities that are hard to value and trade, were 20 percent of assets at the end of July. That was higher than any other U.S. junk bond fund with at least $500 million in assets, according to a Reuters analysis of fund disclosures.

And the fund had 76 percent of its portfolio exposed to very low rated "CCC+" rated securities and below, compared with a median level of 22 percent among similar junk funds, according to analysts at Citigroup. Launched in 2009, Focused Credit found its way into the portfolios of mom-and-pop investors, pension plans and nonprofits, fund disclosures show. It differed from other junk bond funds because it favored creditor claims and stock warrants tied to companies going through bankruptcy.

One of its biggest investors was Boston-based Fidelity Investments' Strategic Advisers Income Opportunities Fund, which had a $128 million stake at the end of October. Fidelity declined to comment on the fund’s current exposure.

Graystone Consulting, Morgan Stanley's independent adviser to institutional and wealthy clients, originally recommended the fund in 2014 via a due diligence report that clearly highlighted the fund’s liquidity risks, Morgan Stanley spokesman James Wiggins said. Graystone then produced an updated assessment in 2015 in which liquidity risk is also highlighted, he added. “Graystone stands behind its review process. Third Avenue has a strong track record as an investment manager and has found historical success in illiquid instruments,” Wiggins said.

BLUNT AND AUTOCRATIC   Continued...

 
The U.S. Securities and Exchange Commission logo adorns an office door at the SEC headquarters in Washington, June 24, 2011.REUTERS/Jonathan Ernst