If you ever read a mutual fund prospectus closely, you'll typically come across a passage that details the fund's right to pay a full or partial redemption not through cash but, rather, through something known as redemption-in-kind or in-kind-redemption, especially if the fund manager believes the redemption request would be disruptive or otherwise inconvenient.
You might be wondering what a redemption-in-kind is all about. It's one of those things that most investors don't think about until they're faced with it, often at the worst possible time.
Mutual Fund Inflows and Outflows
A mutual fund is a type of company (or trust fund, depending upon how it is structured) that pools money together from thousands or millions of individuals and institutional investors. An asset management company invests the money according to a particular investment mandate. This offers economies of scale and convenience to smaller investors who otherwise wouldn't be able to afford to replicate the portfolio.
When a mutual fund is enjoying net inflows of capital, more dollars are coming into the fund than going out. During times of net inflows, redemption requests (when a fund owner wants to cash out and sells their shares) can be funded with the cash coming in from other, newer investors. This means that the fund manager won't have to sell off part of the portfolio.
In cases where there are net outflows, some of the fund's investments must be sold to raise money. This can create issues, such as triggering capital gains.
If outflows exceed inflows by a material degree, these issues can become more severe. If the fund held either large or illiquid positions during market downturns, then liquidating assets at fire-sale prices to meet your redemption requirements would harm your remaining investors.
There are typically two solutions that might be employed to avoid letting outflows harm remaining investors: runoffs and in-kind redemptions.
Board of Directors and a Runoff
The board of directors or board of trustees, depending upon how the mutual fund is structured, can vote to put the mutual fund into what's known as a "runoff." Essentially, a special trust fund is created, the assets are transferred to it, and over an extended period of time, perhaps over the course of many years, and the assets are sold under, hopefully, more favorable conditions and terms.
For example, this scenario took place with a previously well-respected firm called Third Avenue, which had sponsored a so-called "Focused Credit" fund that specialized in junk bonds. The junk bond market began to seize and collapse. Investor redemption requests kept coming in as the fund lost money.
Finally, on December 9th, 2015, the fund manager announced that it was not going to honor redemption requests but, instead, put the $789 million of quoted assets shown on the fund's balance sheet (down from $2.75 billion last year) into a runoff.
In-Kind Redemption Distributions
So-called "Redemption in Kind" or "In-Kind Redemption" distributions are made in certain situations. When this happens, instead of receiving cash, the mutual fund hands over the underlying assets on some sort of pro-rata basis to the investor. For example, the largest traditional mutual fund in the United States at the moment is the Vanguard 500 Index Fund, which seeks to replicate the S&P 500.
If some remote-probability event were to come to fruition that caused the portfolio managers to fear that honoring redemptions would harm long-term owners who remained with the fund, it could hand over shares of each of the underlying 505 companies that make up the portfolio at the moment to those wanting to part ways.
The investor would have to open a brokerage account somewhere and have stock deposited, then do with it what they will. As of February 2021, this meant 29% of their assets would arrive in shares of ten companies -- Apple, Alphabet, Microsoft, Tesla, Facebook, Johnson & Johnson, Visa Inc., Amazon, Berkshire Hathaway, and JPMorgan Chase & Co.
What makes the latter situation potentially worse is that the portfolio managers may decide to "drain off," for lack of a better term, the securities with the lowest cost basis—think of shares of Microsoft, Apple, Coca-Cola, or Hershey bought 25+ years ago sitting in some of the major index funds—to reduce the taxation burden of investors sticking with the fund while penalizing the person departing with a bigger bill to the federal, state, and potentially local governments. Of course, this won't matter if you hold your mutual funds within a Roth IRA or other tax shelter.
What's the solution? It's best to avoid things that pay for long-term assets (junk bonds) with short-term funding (open-ended mutual fund structures that allow investors to sell their shares and create cash drains within a single trading day). Otherwise, about the best you are going to do is be aware that you may someday have to deal with one of these outcomes so you can watch what is going on with your fund (or funds) of choice when you read the annual report each year. It's simply part of the risk that comes from investing in pooled structures such as mutual funds.