You might be wondering what redemption-in-kind is all about. It’s one of those things that most investors don’t think about until they’re facing it, often at the worst possible time.
Mutual Fund Inflows and Outflows
A mutual fund is a type of company (or trust fund, depending upon how it is structured) that pools money together from thousands or millions of individuals and institutional investors. An asset management company invests the money according to a particular investment mandate. This offers economies of scale and convenience to smaller investors who otherwise couldn’t afford to replicate the portfolio. When a mutual fund enjoys net inflows of capital, more dollars are coming into the fund than going out. During times of net inflows, redemption requests (when an investor wants to cash out and sell their shares) can be funded with the cash coming in from other, newer investors. This means that the fund management won’t have to sell off part of the portfolio. In cases where there are net outflows (more going out than coming in), some of the fund’s investments must be sold to raise money. This can create issues, such as triggering capital gains. If outflows exceed inflows by a material degree, these issues can become more severe. If the fund held either large or illiquid positions during market downturns, then liquidating assets at fire-sale prices to meet your redemption requirements would harm your remaining investors.
Board of Directors and a Runoff
Depending upon how the mutual fund is structured, the board of directors or trustees can vote to put the mutual fund into what’s called a “runoff.” Essentially, the board creates a special trust fund, and the assets are transferred into it. Then, over an extended period of time—sometimes many years—the assets are sold under more favorable conditions and terms (hopefully). For example, this scenario took place with a previously well-respected firm, Third Avenue. It had sponsored a so-called “Focused Credit” fund that specialized in junk bonds. In 2015, the junk bond market began to fluctuate and caused a panic in bond investors. As a result, redemption requests began pouring in as the fund lost money. Finally, on December 9th, 2015, the fund manager announced that it was not going to honor redemption requests but, instead, put the $789 million of quoted assets shown on the fund’s balance sheet (down from $2.75 billion the previous year) into a runoff.
In-Kind Redemption Distributions
So-called “Redemption in Kind” or “In-Kind Redemption” distributions are made in certain situations. When this happens, the mutual fund hands over the underlying assets on a pro-rata basis to investors instead of giving them cash. For instance, suppose a market event were to occur that caused the Vanguard 500 Index Fund managers to fear that honoring redemptions would harm long-term owners who remained with the fund. Instead, management might hand over shares of each of the underlying companies that make up the portfolio to those wanting to exit the fund. This situation has the potential to worsen if the portfolio managers decide to “drain off” (for lack of a better term) the securities with the lowest cost basis—the original price of a stock when the fund purchased them—to reduce the tax burden of investors who stick with the fund. This course of action penalizes the people that depart the fund by passing higher taxes off to them. These could be shares of Microsoft, Apple, Coca-Cola, or Hershey purchased 25 years ago or more that sit in many major index funds. However, if you hold your mutual funds within a Roth IRA or other tax shelter, this won’t affect you.
The Solution
What’s the solution? You should avoid paying for long-term assets (junk bonds) with short-term funding (open-ended mutual fund structures that allow investors to sell their shares and create cash drains within a single trading day). Otherwise, the best you can do is to be aware that you may someday have to deal with one of these situations. Watch what is going on within your fund (or funds), and read the annual report each year. Also, ensure you understand it’s one of the risks you take on when you invest in pooled structures such as mutual funds.
