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

A look at the disturbing trend of funds that are loading up on non-public tech startups.

May 4, 2014 at 12:30PM

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.

Tim Hanson owns shares of Google (C shares). The Motley Fool recommends BlackRock, Facebook, and Google (C shares) and owns shares of Facebook and Google (C shares). Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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