Clients Pull Cash From Sequoia Fund Investor, Get Stock Instead

Ted

FYI: (Click On Article Title At Top Of Google Search)

When Tom Bentley tried to pull his money from a mutual fund troubled by its large stake in Valeant Pharmaceuticals International Inc., he instead received shares in a Springfield, Mo. auto-parts retailer.

Sequoia Fund Inc. sent the retired computer hardware engineer about 5% of his money in cash and the rest was stock in one company–O’Reilly Automotive Inc. Mr. Bentley said he sold the shares as soon as they appeared in his account on April 7, but they had already dropped in value
Regards,
Ted
https://www.google.com/#q=Clients+Pull+Cash+From+Valeant+Investor,+Get+Stock+Instead++wsj

Lawlar

This is a story that deserves a lot of thought and discussion.

One of the fundamental beliefs we’ve had when investing in funds is that we will get our money back when we want it. Sure, we’re vaguely aware that somewhere in the legalese (those pesky lawyers) there is language that distributions could be delayed during difficult times, but we figured that we weren’t the type to sell during those times of distress and that once the selling panic was over the funds could resume normal operations. And we might have read somewhere that distributions could be made in the form of stocks instead of cash, but we believed that couldn’t happen in the good quality funds that we invested in, those were simply things that happened in small high risk funds run by fraudsters.

But now it’s happened. A highly respected fund has refused to cash out one of its investors, and has instead given an investor some crummy stock that the fund doesn’t want, that probably has a tax obligation that the fund will avoid by distributing the stock. The investor will have to pay the fees to sell the stock, incur the risk the stock will decline in value, and may have to pay the capital gain on the sale.

Talk about breach of fiduciary duty!!!

This is a risk that I’m not sure I want to take with my retirement funds. I’m going to take a closer look at my funds and if they are not backed up by a big reputable fund family I’m going to question if they could be subject to this sort of risk.

It may also make sense to reconsider investing the old fashioned way: Buying stocks one at a time. Anyone still subscribe to Value Line?

jerry

I am a somewhat unhappy Sequoia investor though it has worked out over the many years I have owned it.But these I am shocked remarks remind me of Casablanca. Not only does the prospectus make it very clear that you might get stock bui that fact is very prominent (You don't have to read fine print))A bigger problem for me is that until I read the annual investor day minutes(held in may) I was not really aware of the controversy around Valeant and I did not get a copy of the report till sometime in August

hank

Jerry's correct above. And I won't argue that Sequoia management screwed up royally in managing their fund.

But here's the crux of the WSJ article:
"Sequoia’s repayment approach, called a “redemption in kind,” is part of a longstanding fund policy that allows it to give shareholders mostly stock if they are pulling out $250,000 or more. A person close to the firm said it has done thousands of in-kind transactions over many years and that the majority are done for redemptions in excess of $1 million."

If Sequoia failed to disclose RIK in its Prospectus that's a serious legal matter. In all likelihood it was mentioned. I've seen similar language in many prospectuses for my funds. It's not uncommon. Bottom line: Read and understand your Prospectus before you invest.

Additionally ... How many on this board will ever have occasion to pull a quarter-million dollars from one fund all at once (which is what triggered the RIK in this case)?

WSJ fails to address Mr. Bently's age and circumstance. Sequoia's annual/semi-annual reports should have revealed to him that Sequoia was concentrated in only a dozen or so securities. Ed S. addresses this issue in David's April 1 Commentary. In a nutshell: Potential rewards are high with a concentrated portfolio. So are the risks. If I'm reading Ed correctly, he has serious reservations concerning the suitability of highly concentrated portfolios for retirees.

msf has a good thread running on the topic of disclosure. Personally, I'm often guilty of clicking on "Accept these terms" without due diligence whenever Apple, Amazon or PayPal update their terms of use (not smart I know). But I love reading financial literature and so very much enjoy reading over prospectuses and reports for the funds I own. (And don't like the dumbed-down "summary" prospectuses either.)

David_Snowball

The prospectus text, which is unusually clear on the subject:

Payment of Redemption Requests

Unless otherwise prohibited by law, the Fund may pay the redemption price to you in cash or in portfolio securities, or partly in cash and partly in portfolio securities.

The Fund has adopted a policy under which the Fund may limit cash payments in connection with redemption requests to $250,000 during any ninety (90) day period. As a result, the Fund may pay you in securities or partly in securities if the amount of Fund shares that you redeem is more than $250,000.

It is highly likely that the Fund will pay you in securities or partly in securities if you make a redemption (or series of redemptions) in an amount greater than $250,000.

David

davidrmoran

Ah, so many things in life are highly unlikely until they're not

Mark

Interesting. While I've always been aware that RIK was a possibility it hadn't occurred to me that the fund might do so in all of 'ONE' security and one of their choosing. I'm not sure why I falsely assumed I might get a basket of the funds holdings. On the other hand a single security would hopefully cut down on the selling transaction fee.

fundalarm

i am amazed their mutual fund had such language.. institutional commingled funds do. so do private funds - hedge funds and such. i went though many act 40 prospectuses and haven't seen such disclosure - very unusual case. in europe, however, redemption in kind (or, they call it "in specie") is part of the standard mutual fund prospectus language. (so is the swing pricing - ability to allocate costs to investors with large cash flows that usually increase the fund's trading costs.)

i wonder whether this prospectus language was there at the inception or added fairly recently. also, receiving a single stock vs pro-rata share of all investments is quite unusual. i bet we'll hear more about this.

FA

FundStudent

Tom Bentley is lucky that Sequoia did not send him shares of VRX, Valeant Pharmaceuticals International Inc.

hawkmountain

Totally disgusted with Sequoia, a core holding in my kids' Roth IRAs for 9 years. I pulled them out several weeks ago. Alas, the kids do not qualify for O'Reilly or VRX, or whatever else SEQUX wants to get rid of for their affluent customers. I shall look for a box of used auto parts on my doorstep.

hank

Fundalarm said: "I am amazed their mutual fund had such language ... i went though many act 40 prospectuses and haven't seen such disclosure ..."

From Full Prospectus for Oppenheimer Capital Appreciation Fund (page 16):

Redemptions “In-Kind.” Shares may be “redeemed in-kind” under certain circumstances (such as a lack of liquidity in the Fund’s portfolio to meet redemptions). That means that the redemption proceeds will be paid in securities from the Fund’s portfolio on a pro-rata basis, possibly including illiquid securities. If the Fund redeems your shares in-kind, you may bear transaction costs and will bear market risks until such securities are converted into cash.

Haven't checked, but I'm pretty sure this is standard boilerplate for all their funds.
https://www.oppenheimerfunds.com/investors/doc/Capital_Appreciation_Fund_Full_Prospectus.pdf?dig_asset_metrics=done

davidrmoran

yeah, I was surprised at the assertion, having seen text along these lines for more than one Fido fund (and for other funds where I have been contributing to or indeed editing the text):

Redemption proceeds may be paid in securities or other property rather than cash if the Adviser deems it in the best interests of the fund

yada

I'd say there's nothing to see here.

fundalarm

right, 'pro-rata' basis is more common, if such language exists.
there are a couple of fund families without such language.

in kind distribution, similar to creation of a side-pocket, is an admission by the fund sponsor that they had failed. no one forgives this. several hedge funds did survive the side pockets -- very large ones such as Citadel, but Highbridge and others folded. for a mutual fund it is a kiss of death. that is why even having this language in the documents the management companies would do anything possible to avoid the process.

it seems that sequoia is moving to orderly liquidate the fund -- hence an attempt to protect the remaining shareholders.

hank said:

Fundalarm said: "I am amazed their mutual fund had such language ... i went though many act 40 prospectuses and haven't seen such disclosure ..."

From Full Prospectus for Oppenheimer Capital Appreciation Fund (page 16):

Redemptions “In-Kind.” Shares may be “redeemed in-kind” under certain circumstances (such as a lack of liquidity in the Fund’s portfolio to meet redemptions). That means that the redemption proceeds will be paid in securities from the Fund’s portfolio on a pro-rata basis, possibly including illiquid securities. If the Fund redeems your shares in-kind, you may bear transaction costs and will bear market risks until such securities are converted into cash.

Haven't checked, but I'm pretty sure this is standard boilerplate for all their funds.
https://www.oppenheimerfunds.com/investors/doc/Capital_Appreciation_Fund_Full_Prospectus.pdf?dig_asset_metrics=done

msf

Like others, I was surprised to see the Sequoia prospectus excerpt that David S posted. Not so much because it warned to expect redemption in kind (which is exceedingly unusual), but simply because it gave rules - over $250k in 90 days.

Yet (keeping @ducrow in mind), the first fund I checked was OAKBX, that had somewhat similar language:

Each Fund is obligated to redeem shares solely in cash up to the lesser of $250,000 or 1% of the Fund’s NAV during any 90-day period for any one shareholder. Redemptions in excess of those amounts will normally be paid in cash, but may be paid wholly or partly by a distribution in kind of securities.

The main difference is highlighted - Oakmark doesn't expect to redeem in kind, even if you exceed the $250K limit.

But pro-rata? I too thought that was almost everywhere. Yet it's not in Oakmark, and it's not in the next family I checked, Vanguard. No pro-rata qualification in the in-kind section, at least in Primecap's prospectus.

Regardless of whether an in-kind redemption is pro-rata or not, the fund comes out a tiny bit better when it redeems in-kind. It gives the shares to the investor at full price (no market movement), and the investor gets less than 100% value as the sales push the price down.

That market movement affects the fund's remaining securities also. If the redemption is pro-rata, the percentage impact on the fund's NAV will be the same as if it had sold the shares itself.

But suppose the fund has a really volatile, poor performing stock that it unloads on all the redeeming shareholders. Now it has eliminated (or reduced) its position in that one stock. So it no longer cares how the market moves as those shares are sold off by the individual investors.

For this reason it seems that funds would be better off dumping their dogs when redeeming in-kind, rather than redeeming pro-rata. Unless the prospectus explicitly requires pro-rata redemptions.

Old_Joe

"But suppose the fund has a really volatile, poor performing stock that it unloads on all the redeeming shareholders. Now it has eliminated (or reduced) its position in that one stock." "For this reason it seems that funds would be better off dumping their dogs"

@msf- Exactly- the first thought that crossed my mind when I read the paper yesterday morning was "I wonder how the O'Reilly Automotive" stock is doing?"

hank

hawkmountain said:

Totally disgusted with Sequoia, a core holding in my kids' Roth IRAs for 9 years. I pulled them out several weeks ago. Alas, the kids do not qualify for O'Reilly or VRX, or whatever else SEQUX wants to get rid of for their affluent customers. I shall look for a box of used auto parts on my doorstep.

Happen to own a very old pickup that's always is in need of repair. Wondering if I should buy some of this fund? Maybe receive a box of those parts on the cheap?

There may also be some similarities with this fund ...

broken down clunker

unsafe at any speed

buyer beware

msf

To be clear - a stock, no matter how good or bad, is valued at the current market price. ISTM that liquidity/volatility is the most important factor in what stocks the fund hands over to its investors redeeming in kind. That's why pro-rata loses.

Here's an extremely simplified example to demonstrate what I'm trying to say:

Fund contains just two stocks A and B in equal value. Let's say 1,000 shares of A and 1,000 shares of B, both stocks priced at $100.

Stock A is a thinly traded stock and any sale immediately triggers a 12% drop in stock price. Stock B is a huge company and its price barely moves when the shares in the fund are sold off. (1,000 shares are a drop in the bucket for this huge company).

The fund gets redemption requests for 1/4 of the fund.

If the fund distributes pro-rata (250 shares of A, 250 shares of B), it will still have a 50/50 mix of A and B. Because the investors are busy selling off their shares, A will drop in value by 12%. So the fund's total value (and NAV) will drop by 6% (half the fund is in A).

If the fund distributes just A shares, then it's left with 1/3 in A shares (500 shares), and 2/3 in B shares (1,000 shares). Now when the investors sell off their A shares, the fund's A shares (1/3 of the fund) will drop by 12%. So the fund's total value will drop by just 4%, rather than the 6% had it distributed pro-rata.

The redeeming investors are the ones that are disproportionately hurt - instead of getting a 50/50 mix of stock (that would drop 6% as they tried to sell the shares), they got all A shares that dropped 12% in value as they hit the market.

Derf

Moral of the story. Don't hold more than $250K of MF.
Derf
P.S. It's not a problem here !

claimui

Response from Sequoia's David Poppe:

For many years Sequoia Fund has clearly disclosed that we can and do pay large redemptions with securities rather than cash, and we have done so thousands of times before this year without incident. So we were puzzled by “Sequoia Clients Get Stock Shock” (Business & Finance, April 9) questioning the practice as a “shock” to investors and trying to tie recent in-kind redemptions to our Valeant stake. This policy isn’t new, is unrelated to the ups and downs of our fund and, specifically, is unrelated to our holding in Valeant.

We redeem with shares to benefit our continuing shareholders, who might otherwise pay capital-gains taxes on the sale of appreciated stock that might be required for redemptions. By redeeming in kind, our 20,000 continuing Sequoia shareholders will pay lower capital-gains taxes in the future. Our goal is always to be tax-efficient and to do what is right for continuing shareholders. For a departing shareholder, there is no tax or other consequence to receiving stock instead of cash, aside from the minor inconvenience of having to sell a security upon receipt. We take care to always deliver stocks that trade in sufficient volume so that the exiting shareholder can sell them immediately without depressing the market for a particular security.

David M. Poppe

President

Sequoia Fund

New York

http://www.wsj.com/articles/sequoias-redemption-with-securities-is-tax-efficient-1460583731

davidrmoran

an undefensive and low-keyed explanation

Ted

@MFO Members: Here is the WSJ article that was linked by claimui. Click on article title at top of google serarch.
Regards,
Ted
https://www.google.com/#q=Sequoia’s+Redemption+With+Securities+Is+Tax+Efficient+wsj

BobC

Investors should be aware that most ETFs have similar language in them. Should there be a credit problem, a real credit problem, and shareholders of bond funds try to bale out, this is what the bond ETF could do...send them actual pieces of a bond in the portfolio. Scary? Yes, but that is why it is important to actually read a prospectus. This should not surprise folks who take the time to do it.

msf

Isn't that the whole idea of ETFs? That APs generally redeem in kind (thus providing the tax efficiency that is purportedly lacking in open end funds).

Admittedly there are some types of ETFs that typically trade in cash, but they're the more esoteric ones (inverse and leveraged, and I believe commodities). But for the most part, the expectation (as marketed) when shareholders (i.e. APs) redeem (not sell) shares, the sellers get the underlying securities (or whatever is in a Creation Unit).

For example, from BOND's prospectus: "Except when aggregated in Creation Units, shares of a Fund are not redeemable securities. Shareholders who are not Authorized Participants may not purchase or redeem shares directly from a Fund."

There is a potential tracking problem with ETFs that hold illiquid assets (e.g. bonds in a credit crunch, to use your example). When normal (not AP) shareholders try to bail on an exchange, the market (not NAV) price gets depressed. APs may decline to step in, because they know they'll get illiquid assets they can't dump at a profit (the spread between the supposed NAV of the underlying assets and the market price of the ETF).

So the market price of ETFs can go into free fall. That's a related but different issue.