ORLY O Reilly Automotive Inc

When Tom Bentley tried to pull his money from a mutual fund troubled by its large stake in Valeant Pharmaceuticals International Inc., he instead received shares in a Springfield, Mo. auto-parts retailer.

Sequoia Fund Inc. sent the retired computer hardware engineer about 5% of his money in cash and the rest was stock in one company–O'Reilly Automotive Inc. Mr. Bentley said he sold the shares as soon as they appeared in his account on April 7, but they had already dropped in value.

"It has been pretty horrendous," Mr. Bentley said.

Typically, mutual fund investors expect cash instead of stock when they ask for their money back. But investors seeking to pull large sums from Sequoia are getting a combination, according to people familiar with the matter.

The $5.5 billion fund is wrestling with heavy withdrawals as clients asked to pull more than $500 million in the first quarter, according to Morningstar Inc.

Sequoia has been hit hard by its big stake in Valeant. The drug company's shares are down roughly 65% this year amid questions about its business and accounting practices, though they rallied earlier this week.

Sequoia's repayment approach, called a "redemption in kind," is part of a longstanding fund policy that allows it to give shareholders mostly stock if they are pulling out $250,000 or more. A person close to the firm said it has done thousands of in-kind transactions over many years and that the majority are done for redemptions in excess of $1 million.

"It's a perfectly legitimate strategy," said Jeffrey Sion, a partner at Dechert LLP, who specializes in investment funds and tax.

But the move has come as a surprise to some investors and their advisers. While it is common for mutual funds to reserve the right to hand out a basket of securities to large, sophisticated institutional investors, it is rare for managers to use them to redeem individual investors, lawyers and analysts say.

It is also less common for managers of stock funds to redeem in-kind because equities, which trade on exchanges, are more easily bought and sold than less liquid fixed-income assets.

"If you're a retail investor, who wants to get stocks? If you're getting out of fund, presumably you're selling because you want cash," said Michael Rosella, a partner at Paul Hastings LLP, who specializes in investment management. "Most funds have the right to do it, but you're not going to do it if you don't have to," he said.

Sequoia's large stake in Valeant, which at one point last year accounted for more than 30% of its portfolio as the drug company's share price rose, has since hurt Sequoia's performance following a sharp decline in the stock. The fact that the long-venerated mutual fund let the position get so large has also hurt its credibility with investors, the fund has acknowledged.

In addition to the withdrawals, the woes led to the resignation last month of lead Sequoia manager Robert Goldfarb, the departure last year of two independent directors concerned about the size of the position, and shareholder litigation. The fund was down 11% year to date through Thursday, while the broader market is about flat.

"In-kind" redemptions have benefits for funds such as Sequoia that are experiencing redemptions. Unlike with sales for cash, the fund doesn't have to recognize a capital gain on such transactions. As a result, remaining investors don't bear the tax implications of sales associated with exiting shareholders, according to fund and tax lawyers.

Meeting redemptions with shares also keeps managers from having to sell stock to raise cash, which fund analysts say can weigh on performance.

Sequoia's policy tells shareholders it is "highly likely" that they will receive all or part of their withdrawal in securities if they are pulling more than $250,000 from the fund, regardless of whether they have a bank or brokerage account to which stocks can be delivered.

The fund has seven days to meet redemption requests and determines which stocks investors will receive. The firm typically pays out in stocks with high unrealized capital gains that trade often, and it advises redeeming shareholders to sell the securities they receive at market close on the day they exit the fund, said a person close to the firm.

But such redemptions often shift risk and burdens from the fund to its selling investors, especially if they hold the fund in a taxable account. Those who receive all or most of their assets in stock may not have enough cash to pay taxes due on the redemption without selling the stock.

In addition, funds don't necessarily give investors a pro-rata basket of stocks, which can expose the newly given holding to market risk from lack of diversification.

The stock shares also may rise or fall in value after the investor receives them, producing capital gains and losses. In this case, the taxable gain or loss is measured from the value of the stock on the day of the redemption, according to Robert Willens, an independent tax expert based in New York.

Selling those shares will also incur transaction costs that can be steeper for individual investors than large investors that benefit from longstanding relationships with banks and brokers and economies of scale.

Write to Laura Saunders at laura.saunders@wsj.com and Sarah Krouse at sarah.krouse@wsj.com

(END) Dow Jones Newswires

April 08, 2016 12:25 ET (16:25 GMT)

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