Funds' Private Affair

In 2004, the SEC charged Van Wagoner Capital Management with deliberately undervaluing private investments in its mutual funds to make it seem as if illiquid securities were within the 15% limit. The settlement with regulators did not confirm or deny any wrongdoing.

Illiquidity Issues

"When things are illiquid, then the supply is limited, and that increases the potential for returns," says Trubey. "It's the same sort of thing you see with micro-caps. You can potentially hit massive home runs with this sort of thing."

However, the liquidity issue can also harm a fund that invests directly in private companies, like (TIFQX Quote)Firsthand Technology Innovators. If a company that Firsthand invests in hits a major bump, the holdings are hard to trade.

"Oftentimes, the only option if you buy a stake in a private company is to sell it back to the company," says Trubey. The problem is similar for funds that buy private-company debt. If those bonds falter, the only market option is to sell them back to the company.

And watch out for the fees at funds that invest in private equity. The holdings could push up expenses, because it takes a legal team to thoroughly review the deals, and it takes more work for the manager to fairly value securities that are not priced by the market.

Firsthand Technology Innovators, which has an average five-year return of negative 8.15%, has a 1.95% expense ratio. Legg Mason Opportunity fund has a 2.08% expense ratio, but a five-year return of 9.97%.

"Bill Miller at Legg Mason is investing in private equity through PIPE deals, and he's one of the brightest guys out there and a very long-term investor," says Trubey. "If the Opportunity Fund's holdings are illiquid, Miller probably wasn't going to sell the stake quickly anyway, and he can ride out a bad period in whatever the security is." The Opportunity Fund is down 4.81% year to date.

"When you're dealing with these kinds of stakes, it demands that you trust the manager more," says Trubey.