The news on December 10 that Third Avenue Management hadsuddenly closed down its Third Avenue Focused Credit Fund (TFCVX),while imposing “gates” to restrict shareholder redemptions, tookmany advisors by surprise.

Some weren’t aware that the Investment Company Act of 1940allows mutual funds to indefinitely suspend redemptions – andindeed the law allows this only in emergencies.

The SEC’s own guidance for InvestingWisely in mutual funds states: “Mutual fund investors canreadily redeem their shares at the current NAV — plus any fees andcharges assessed on redemption — at any time.”

As Morningstar noted in its coverage: TFCVX had experienced $1.3billion in net outflows through the first 11 months of 2015 and itstotal return was -27% year-to-date through early December.

However, other mutual funds have experienced similarimpacts, without liquidating and gating.

Could advisors have foreseen this situation in their duediligence, and taken steps to protect investors from losses,uncertainty and lack of liquidity?

The answer is – perhaps so, if they knew where to look.

For fixed-income funds, Morningstar reports the percentage ofassets in “not rated” bonds, which was 41% for TFCVX. That shouldhave been red flag #1 for investors concerned about liquidity.

But to really protect clients, advisors must dig deeper – intothe Notes to the Financial Statements of the most recent annual orsemi-annual report.

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These notes break down portfolio holdings into three levels:Level 1 reflects unadjusted prices quoted in active markets foridentical assets; Level 2 reflects valuation inputs other thanquoted prices that are observable; Level 3 reflects unobservableinputs, including the fund’s own valuation/pricing assumptions.High amounts of Level 2 and 3 assets are red flag #2.

TFCVX reported total assets on 4/30/15 of $2.3 billion, of which74.4% were Level II and 17.3% were Level III. Just 8.4% of thefund’s portfolio was in the Level I category for which daily quoteswere readily available.

This created a problem not only for purposes of liquidity, asthe fund’s redemptions accelerated. It also meant that orders tobuy or redeem fund shares were made at NAVs that were estimates atbest and guesses at worst.

It’s important to note that short-sellers were largelyresponsible for TFCVX’s demise.

They could see from public records the huge concentration inLevel II and II assets and also the specific illiquid high-yieldbonds the fund held. This transparency is a special hazard ofhigh-yield and emerging market bond mutual funds.

Since TFCVX’s demise, it has been cited as one of the bestreasons to pursue exposure to these asset classes through eitherETFs or closed-end funds, neither of which have the samevulnerabilities to redemptions or short-sellers as mutualfunds.

If you recommend high-yield or emerging market bond funds, makesure to learn the lessons of this fund’s demise.

The due diligence to uncover red flags isn’t very difficult ortime-consuming, and it will become more important going forward. Inmonths to come, there is nothing to prevent the predatory tacticsof short-sellers or the liquidity/gating of investors from beingrepeated with other mutual funds in these categories.