the Sequoia Fund (iii)

tax factors

Mutual funds are corporations of a special type.  In return for agreeing to limit their activities to portfolio investing and to distribute basically all their net realized gains to shareholders, mutual funds are exempt from paying corporate tax on those profits.  Net here means after subtracting realized losses.  Realized means that the winning/losing stock has been sold and the gain/loss recorded in the fund’s accounts.

Typically, distribution of gains occurs once a year, in November or December.

In my experience, almost no one other than the fund manager thinks much about the profits and losses imbedded in a fund, whether realized or unrealized.  There are certain situations, though, where they can be important.

net losses

In my career, I’ve turned around a couple of global mutual funds where the single most valuable asset on the day I arrived was the funds’ realized tax losses.  They allowed me to trade the portfolio aggressively without shareholders incurring any tax liability.

net gains

Most funds today are in the opposite situation.  Given that the S&P 500 is at all-time highs, funds tend to have large accumulated unrealized gains.  Tax on these gains is only due when stocks in the portfolio are sold and profits distributed to shareholders.  Also–and this is important–the tax is the obligation of the person who receives the yearend distribution.  That’s not necessarily the same as the person who enjoyed the rise in net asset value of the fund.

sales and redemptions

The potential per share value of losses falls if the fund is having net sales (meaning the number of outstanding shares is increasing), and rises if it is having net redemptions.

The potential per share tax obligation of gains also falls if the fund is having net sales and rises if it is having net redemptions.

the Sequoia situation

If the Wall Street Journal is correct, Sequoia is experiencing substantial net redemptions.  If it has to sell stocks where it has large gains in order to meet these outflows, it could be setting the stage for shareholders who stay loyal to the brand to incur a large income tax liability this year.

What the firm appears to be doing to reduce this burden on remaining shareholders is to meet large (over $250,000) redemptions mostly by distributing shares of stock from the portfolio rather than by (selling them and distributing) cash.

While this may be unusual and inconvenient to redeeming shareholders, it does not hurt them, since their cost basis on in-kind distributions is not the fund’s.  Rather, it’s the closing price on the day they receive the stock.  At the same time, distributing stock protects shareholders who don’t redeem from getting a whopping income tax bill at yearend.





the Sequoia Fund (ii)

large position sizes

At the end of June 2015, the Sequoia Fund had assets of $8.7 billion, of which 28.7% was in shares of Valeant Pharmaceuticals (VRX) and another 10.6% in Berkshire Hathaway.

How did these positions get so large?

a.  The portfolio managers chose to have nearly 40% of their fund in two names.  In fact, as VRX began to decline in the second half of last year, the managers bought more.

Don’t ask me why.  To my mind, following Bernard Baruch’s dictum to have all one’s eggs in one basket may have been ok for the renowned speculator way back when, but it makes no business or economic sense for mutual funds today.  According to the Wall Street Journaltwo members of the board of directors of the fund resigned last year because they disagreed so strongly with the strategy.

b.  SEC diversification rules permit this.  The pertinent regulation has two parts:

  1.  The fund can’t make a purchase of a security if doing so would make its total holding in the security more than 5.0% of fund assets.  At the 5% threshold, the manager can allow the existing position to grow; he just can’t buy more.  Growth can come because the security is outperforming and/or because the total asset size is shrinking.
  2. 25% of the fund’s assets are exempt from rule 1.

The second provision is much less well-known than the first.  I’m not sure why the SEC wrote the rules the way it did (my guess would be lobbying from the fund management industry), but I can’t recall an instance where having a whopping position like Sequoia has with VRX didn’t end in tears.  And I can only recall two other cases, one involving a junk bond fund, another a Pacific Basin fund, where managers took such large bets with shareholder money.

More tomorrow.


the Sequoia Fund and redemption in kind

I read in the Wall Street Journal over the weekend that the Sequoia Fund (assets of around $5 billion) was experiencing heavy redemptions during 1Q16 and met them for some shareholders “in kind.”

Sequoia:  a first glance

I don’t know Sequoia at all.  A quick check of its December 2015 annual report shows the fund had what I judge to be a very unusual portfolio structure.  At that time Valeant Pharmaceuticals (VRX) made up 20% of assets (down from an even more whopping 28%+ in June of last year); Berkshire Hathaway, classes A and B, comprised another 13%.  That’s a third of the fund in two names.  Very concentrated, in my view.

Unfortunately for holders, VRX fell by 60% during the second half of 2015–during which time Sequoia boosted its position from 11.2 million shares to 12.8 million–before losing 2/3 of its remaining value since this January 1st. Hence the Sequoia redemptions …and the retirement of the fund’s senior portfolio manager.

The Journal reports that, in accordance with long-term fund policy, redemptions of $250,000 or more are being met substantially in kind, meaning that the seller is being paid mostly through a transfer of stock held in the fund portfolio, rather than in cash.  The WSJ cites one customer who received about 5% of his money in cash, the rest in shares of O’Reilly Automotive (ORLY).  That would probably mean less than 1,000 shares of a stock that trades 750,000+ shares a day.  So no liquidity problems.  Commission on the sale, other than benighted souls who patronize traditional high-cost brokers, isn’t a big deal, either.

How is this possible?

According to the WSJ (I haven’t checked, but I presume it’s a boilerplate feature of the prospectus), Sequoia discloses the policy of redemption in kind in its regulatory and marketing materials.

my thoughts:

I don’t ever recall hearing about redemptions in kind for retail investment products   before, although I suspect the provision is contained in every mutual fund and ETF prospectus.  The words “in kind” may not be there, but a general description of emergency measures likely is.

“In kind” strikes me as a draconian measure.  It certainly discourages/punishes redemptions.  And it’s not the sort of thing that encourages a customer to return at a later date.

It probably minimizes downward pressure on portfolio holdings from what would otherwise be forced selling by the fund.

It deals with tax issues in a way that doesn’t harm the redeeming customer and favors remaining shareholders.

How did the VRX position get so large?


More tomorrow.