Are You Contributing To A Tech Bubble With Mutual Funds?

Mutual funds are commonly thought to hold primarily publicly-traded companies, but a growing number of funds have diversified into privately-held firms. According to Barron’s, more than 100 mutual funds have invested in privately-held start-ups like Uber, Dropbox, First Data and Pinterest. Many of these companies have experienced tremendous growth, as technology continues to disrupt new areas of the economy—but the gains come at a cost.

With Square Inc.’s (NYSE: SQ) down round initial public offering, many investors are questioning whether mutual funds holding these securities may be at risk. The SEC announced that it would be looking into the practices used by mutual funds to value start-up shares, especially since different mutual funds have reported different valuations for the same companies. Of course, the true value is difficult to determine given the lack of a liquid marketplace.

These dynamics impact a surprisingly large number of Americans. For example, the $100+ billion Fidelity Contrafund (FCNTX) holds hundreds of millions of dollars worth of start-ups like Pinterest, Uber, Dropbox, SpaceX, 23andMe and Blue Apron, according to its latest N-Q SEC filing covering the September 30, 2015 period. The valuations of these start-ups are at the core of the problem since they can quickly move in either direction and add significant risk.

There are a number of different ways that mutual funds value start-ups and other privately-held companies, although there’s no standard system used throughout the industry.

Often times, a mutual fund will look at a start-up’s most recent funding valuation, the valuation of publicly-traded competitors and broader equity indexes. Liquidity is another key concern since the shares of these start-ups cannot be easily sold like publicly-traded equities on major exchanges. Mutual funds don’t disclose their valuation techniques publicly in great detail, citing competitive reasons, but there are stark differences between funds.

The SEC’s last valuation review found start-up valuation methods to be appropriate, but concerns of a tech bubble have reignited regulatory interest in these techniques. Since mutual funds are permitted to hold up to 15% of their assets in illiquid investments, individual investors may be exposed to a high amount of risk—especially if the industry were to experience a liquidity crisis and start-up shares were unable to be liquidated at reasonable prices.

There are a number of ways that individual investors can look up their exposure and hedge their risks in order to sleep a little more soundly at night.

The SEC requires mutual funds to submit an N-Q filing each quarter that outlines their holdings, which can provide insights into whether or not a fund holds shares in a start-up. If start-ups are present in the filing, investors can add up the exposure to determine what percentage of the total portfolio they account for and how much risk that entails. Tracking start-ups between N-Q filing periods and between mutual funds can provide an idea of pricing reliability as well.

There’s no easy way to hedge against start-up exposure, since they cannot be short sold and no options trade on them. In some ways, a put option against the tech sector may be one way to hedge bets, but the best way may be to simply select mutual funds with limited exposure. It’s also worth noting that some exposure may be appropriate, especially with many start-ups driving returns for venture capitalists that are well in excess of the public markets.

Mutual funds may be associated with large-cap publicly-traded equities, but many funds have begun to invest in privately-held start-ups—ranging from Fidelity’s Contrafund to the T. Rowe Price Growth Stock Fund (PRGFX) and the Morgan Stanley Multi Cap Growth Fund (CPOAX). With concerns of a tech bubble and significant volatility, investors may want to take note of these risks and be cognizant of the funds they choose to purchase.