One of the most painful lessons for an investor is discovering that something cannot be sold for what it was believed to be worth. Witness Orange County. But a number of mutual fund investors also have suffered this year.
On Nov. 22, the Van Eck Asia Infrastructure Fund, new this summer, plunged 11 percent in value -- more than twice as much as any other fund that day, according to Morningstar Inc., mutual fund researchers in Chicago.
The same day, two bond funds, Pilgrim Adjustable Rate Securities and Pilgrim Adjustable U.S. Government Securities, fell more than 3 percent each.
That Tuesday was a bad one for Wall Street, with the Dow Jones industrial average tumbling 91 points. But the woes at Van Eck and Pilgrim offered a separate drama.
In each case, the fund was forced by investor redemptions to sell securities, but it could not find buyers willing to pay what the fund had thought the investments to be worth.
"Volatile cash flows and illiquid markets are a bad combination," said John Rekenthaler, editor of Morningstar Mutual Funds newsletter.
So far, only a few areas have been affected, notably funds investing in high-yield municipal and taxable bonds, in emerging markets or in exotic derivatives -- complex securities whose returns are based on other investments.
But if the redemptions that precipitated these crises spread to other markets, Mr. Rekenthaler said, "we could see a lot more daily disasters."
In May, the $1 billion Paine Webber Short-Term U.S. Government Income Fund declined 4 percent in value in two days, mostly because it could not find buyers for its exotic mortgage securities.
In the end, Paine Webber closed the fund for several months and infused $33 million into it to help compensate for the losses.
The fund invests primarily in mortgage-backed securities, including derivatives known as collateralized mortgage obligations, or CMOs, which divide mortgage payments into an array of separate securities.
Some of these securities may gain in value, and others plunge, if interest rates rise, as they have done this year. Because many of these securities do not trade every day, estimating their value is sometimes more art than science, and it was not clear how badly some Paine Webber instruments had been affected by rising rates until redemptions forced liquidations.
A standout loser for the year has been the Piper Jaffray Institutional Government Income Fund, which had some of its largest positions in a form of CMO that makes principal payments on mortgages but no interest. Those securities plunged as interest rates rose because fewer homeowners would pay off their mortgages early.
Managers throughout the industry were under pressure in 1993 to improve returns with derivatives. "It certainly was mentioned to me what outstanding results Piper was having," said Michael C. Brilley, manager of the $36.2 million Sit U.S. Government Securities Fund, also based in Minneapolis. "But we knew what they were doing, and management here thought the risks were too high." Mr. Brilley's fund, which is heavily invested in mortgage securities backed by the federal government but eschews most derivatives, is one of the few in the government securities group to be slightly ahead this year.
It was the stark decline at the Van Eck fund, however, that threw a spotlight on how redemptions can devastate net asset value when selling overwhelms buying in thinly traded markets. The day before it tumbled, the fund was hit with redemptions of $4 million, or two-thirds its total assets.
To meet the redemptions, many Van Eck investments in projects along the Pacific Rim had to be sold at much less than their presumed value. Shareholder redemptions like wise hit the Pilgrim funds, which subsequently were sundered from the Pilgrim Group.
"There appears to be a kind of lag time in pricing," Mr. Rekenthaler said, "which relates to liquidity in poorly developed markets. To me, this undermines the very essential foundation of a mutual fund -- that its daily price fully and accurately reflects its market value."
The Securities and Exchange Commission allows a fund to invest no more than 15 percent of assets in illiquid securities. But the definition of these proscribed instruments was written 25 years ago, before most of today's exotics were developed.
By their nature, open-end mutual funds are vulnerable to liquidity problems because shares can be redeemed on demand. Closed-end funds, however, do not share this vulnerability because their portfolios are fixed. Mr. Rekenthaler said he believes "we should funnel the illiquid securities off into closed-end funds, where they belong."