Simply put, an in-kind redemption is a type of payment that is made in securities or in another format as opposed to cash. Redemptions are paid in-kind for various reasons, chief among them being to minimize tax liabilities for both redeeming and non-redeeming shareholders and to ensure that funds don’t have more outflow than inflow.

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In-kind redemptions are uncommon for mutual fund investors, but they still happen from time to time. This mechanism is useful for funds that are currently experiencing an outflow of capital – more redemption requests than inflows from new investors – and that need to cover the shortfall without endangering the investment of long-term holders. In this case, the mutual fund would offer investors leaving the fund a payment other than cash, usually securities on a pro-rata basis.

Within legal circles, this is often referred to as a non-tax relief valve for mutual funds because it allows them to meet redemption requests without selling securities at ‘fire sale’ prices.

As a general rule, mutual fund managers want to avoid any scenario where they are liquidating a large amount of assets at ‘fire sale’ prices to meet redemption requests. This would undoubtedly harm the fund’s remaining investors.

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As it turns out, in-kind redemptions are ideal for tax-deferred investment vehicles like ETFs, which seek to maximize tax efficiency and minimize capital gains. For that reason, in-kind redemptions are far more common in the ETF world. Although mutual funds have created some ETF classes of shares for some of their products to take advantage of these tax benefits, they generally do not have the same tax-deferred status as their ETF counterparts. As such, in-kind redemptions for mutual funds usually occur on a needs basis and apply primarily to institutional investors. This is due to the minimum size requirements for in-kind redemptions (i.e., 50,000 or more shares). It’s also no secret that retail investors usually want to be paid out in cash and not securities, which diminishes the need for in-kind redemptions for mutual funds.

A fund’s use of in-kind distributions shouldn’t come as a total surprise to investors because its prospectus will detail how it handles redemption requests. Every mutual fund prospectus will include a passage detailing the fund’s right to pay all or partial redemption through in-kind redemptions. This is especially the case if the fund manager believes that redemption requests could disrupt the fund’s performance or serve as an inconvenience.

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In-kind redemptions are rare for mutual funds, but they still happen from time to time. A fairly recent example from Third Avenue, a New York-based asset manager, highlights how a liquidity crunch could impact a fund’s payouts.

In 2015, Third Avenue decided to put a mutual fund into runoff mode, which entails appointing a special trust fund that sells assets at more favorable market conditions. The firm sponsored a ‘Focused Credit’ fund that specializes in junk bonds. However, it was soon overrun by redemption requests as the market for junk bonds began to collapse. As a result of the collapse, the fund’s balance sheet plunged to $789 million from $3 billion.

On December 9, 2015, Third Avenue announced it would not honor redemption requests but instead put its entire quoted assets into a runoff, where they would be transferred and sold over an extended period. Investors still didn’t know how much they would receive or even when they would get their money back. This example, while extreme, showcases the dangers of chasing high yields using risky assets.

Regardless of the asset class – ETF or mutual fund – an in-kind redemption means that securities don’t have to be liquidated to pay out redeeming shareholders. For mutual funds, this mechanism is less common but not necessarily less useful.

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