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From the Desk of MFAM: Why Investors Shouldn't Moonlight

There have been a lot of shocking things in the news lately. Yet the headline that most grabbed my attention the other day was this one from The Wall Street Journal: "Mutual Funds Moonlight as Venture Capitalists."

Perhaps that doesn't seem as shocking to you as anything that's been on the front page of The New York Daily News, but here's why that headline should have you panicked.

The gist
According to the Journal, high-profile mutual fund managers such as T. Rowe Price (NASDAQ: TROW  ) and BlackRock (NYSE: BLK  ) have recently been allocating more capital to tech start-ups that have not yet had an IPO. These start-ups include names such as Airbnb, LendingClub, and Living Social.

Historically, mutual funds have not been active investors in non-public companies, primarily because mutual funds need to be liquid -- able to redeem investor shares for cash when they ask for it -- while non-public stocks are illiquid, since they don't actively trade on any exchange.

What's troubling about this
Illiquidity is not necessarily a good reason not to invest in a company. Provided most of one's fund is liquid, a mutual fund should be able to handle its share of relatively illiquid investments.

However, funds are coming around to this VC approach just as valuations seem to be peaking. With companies such as Facebook (NASDAQ: FB  ) and Google (NASDAQ: GOOG  ) acquiring unproven start-ups such as WhatsApp and Nest for record sums at stratospheric multiples to sales and earnings, an investor needs to be skeptical of just how much longer this trend can run.

But it's just like a mutual fund to get in on a trend just as it's about to bust. After all, there's a well-known phenomenon in this industry known as "window dressing," in which funds purchase shares of companies that have been doing well to show investors that they own them, and perhaps imply that they have owned them for a lot longer than they actually have.

Another troubling aspect is that most mutual funds have no track records as venture capital investors and lack experience analyzing these types of companies. For many, then, the inclusion of non-public tech start-ups in their portfolios is evidence of style drift -- the divergence of what a fund is doing from what it told you it was going to do. This can be dangerous for an investor, because as a fund's style drifts, it may change your own portfolio's return or risk profile without your knowing it -- change that could have consequences for your savings if a few of those unproven, non-public start-ups you didn't know you were investing in go bust.

Bottom-line it for me
If you own mutual funds, look at what your fund is actually holding. Be wary if the fund manager seems to be chasing the hot stocks of the day or if the composition of the fund doesn't seem to match up with the fund's stated strategies and objectives. After all, moonlighting in anything is by its nature the opposite of a sound long-term investment strategy.

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