Alternatives

Third Avenue fund’s meltdown sheds new light on the value of prospectus reading

Some advisers swear by it, while others shun it as useless legalese.

The sudden liquidation of the Third Avenue Focused Credit Fund last week has raised new questions about the value of reading mutual fund prospectuses, as well as what can actually be gleaned from such documents.
While some financial advisers describe fund prospectuses as required reading prior to any investments, others brush them off as outdated legal mumbo jumbo.
“As a general rule, most prospectuses are mainly used for third-party intermediaries like Morningstar and the press, and I think fund companies know that they’re mainly used as a source of secondary information,” said Mercer Bullard, a professor of law at the University of Mississippi and founder of Fund Democracy.
In the wake of the Third Avenue fund’s closing and unusual freezing of investor redemptions, some have argued that it is a perfect example of why you should read a fund prospectus to get a full grasp of the inherent risks.
“If people had read the Third Avenue prospectus they would have at least been aware of the inherent risks in a high-yield bond fund like that, but it’s pretty difficult for the average investor to get a sense of risk just by looking at a list of holdings and objectives of the fund,” said Adam Boughton, owner of Planning Better Lives.
“I do read the fund prospectuses because I know that investors need a translator to really give meaning to what they’re investing in,” he said. “When it comes to bonds, most people still just think of the savings bonds their Aunt Ruth gave them for their 12th birthday.”
Blair duQuesnay, chief investment officer and principal at ThirtyNorth Investments, also sees the value of poring over and keeping diligent files on prospectuses.
“I think the responsibility to read them is mine because I don’t think my clients are doing it,” she said. “They come in the mail, and they’re very thick, and a lot of custodians now allow them to be emailed, which probably means they are being read even less.”
Neither Ms. duQuesnay nor Mr. Boughton had clients invested in the ill-fated Third Avenue fund, but Ms. duQuesnay said she has found information in prospectuses that has prevented her from allocating client assets to a particular fund.
“We pull all prospectuses annually and keep a file on them so we can review them for anything we might have missed,” she said. “What I find particularly valuable is the full list of underlying holdings, because if we see more derivative investments than we’re comfortable with, we won’t invest.”
Hats off to those advisers taking the extra care to read all the fine print, but Mr. Bullard said no level of prospectus reading would have fully protected investors from what happened with the Third Avenue fund.
“I suppose it depends on what you were looking for in the prospectus, but there’s probably not much you could have gleaned from the prospectus that would have made it clear that this fund was experiencing huge redemptions,” he said. “There’s no question the SEC will be looking carefully at the way Third Avenue was pricing securities, and the key will be whether they disclosed the risks of whatever caused the shutdown, which was a combination of liquidity and pricing. The most important aspect of a prospectus is as an enforceable contract.”
According to an analysis of the Third Avenue fund’s collapse by Morningstar, the scenario is unique and not the kind of thing investors should expect to see sweeping across the bond fund universe.
“The majority of high-yield and bank-loan funds are far more diversified by issuer and hold substantial stakes in the higher-quality, and typically more-liquid, tiers of the junk-bond markets,” the Dec. 14 report stated. “As a result, they’re much less likely to be forced to embark on a yearlong liquidation like the one planned for Third Avenue Focused Credit, even in the event of large redemptions.”
Even considering the extreme example of what is happening to investors in the Third Avenue fund, some advisers aren’t seeing any extra protection in the form of reading fund prospectuses.
“I don’t read them and I don’t know anyone who does read them,” said Paul Schatz, president of Heritage Capital.
“Even if I did read them, I know they’re written to protect the fund company instead of the shareholder, and give them the power to basically do anything they want,” he said. “It’s a legalese joke.”
Tim Holsworth, president of AHP Financial Services, is also not a fan of spending time reading prospectuses.
“I don’t read them because I don’t find the information they contain to be of any value to me,” he said. “I can find what I want to know in a far more condensed and relevant fashion elsewhere, such as by reading Morningstar reports.”
In 2009, the Securities and Exchange Commission tried to address the general lack of prospectus reading by introducing summary prospectus rules that are supposed to be shorter and more reader-friendly. While seen as a step in the right direction, it probably will not be enough to bump any prospectus to the top of a best-seller list.
“The fact that they had to introduce the summary prospectus is a sign that, on the whole, investors don’t read them,” said Alec Lucas, a manager research analyst at Morningstar.
Even as a proponent of prospectus reading, Mr. Lucas acknowledges the challenges of getting past the volume and boiler-plate legal jargon that dominates the documents.
“I think it’s a good thing to read through at least one prospectus so you can at least start to understand the genre of the literature,” he said. “There will be certain things you can learn to look for, related to risks and asset allocation. And even skimming a prospectus is better than not reading it at all.”