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A Matter of Disclosure

The SEC has finally weighed in on one of the financial crisis' biggest blunders.

Eric Jacobson, 07/05/2012

The wheels of justice may turn slowly, but they do turn. It has been more than three and a half years since the 2008 financial crisis saw the implosion of two Oppenheimer bond funds. The managers of both Oppenheimer Core Bond OPIGX and Oppenheimer Champion Income OPCHX had made large bets on a slice of the commercial mortgage-backed securities market by purchasing so-called total return swaps for the portfolios. That bet effectively added leverage to the funds, and each sustained massive losses when the CMBS market tanked in 2008. We took an in-depth look at what happened back then, and one of our chief concerns was that Oppenheimer had done very little in its marketing and regulatory materials to explain just how much risk its portfolios had been taking.

It was therefore interesting to see the SEC charge Oppenheimer with making misleading statements about its funds during the 2008 crisis. One key complaint was that the firm had apparently told advisors that the funds could still make back all of their CMBS-related losses. At the same time, Oppenheimer had allegedly been cutting the funds' CMBS exposures (ostensibly at depressed prices) to the point that recovering those losses in the event of a rebound became highly unlikely.

Notably, though, the SEC also knocked the firm for failing to adequately disclose the Champion Income fund's use of leverage. In particular, the agency noted that the fund's prospectus disclosed that it invested in swaps and other derivatives, but it did not "adequately disclose that Champion could use derivatives to such an extent that the fund's total investment exposure could exceed the value of its portfolio securities and its investment returns could depend primarily upon the performance of bonds that it did not own."

Of course, it's not clear that a line mentioning leverage in the fund's prospectus would have made much of a difference for investors. In fact, the SEC mentioned the omission only with regard to Champion Income, presumably because Core Bond's prospectus included a section on derivatives that stated they could generate leverage. It seems likely that if Oppenheimer had thought to include the same section in the prospectus for Champion Income, the firm could have avoided at least one element of the SEC's complaint.

The entire affair, however, is a reminder of just how much more many companies could do to better inform their investors. The good news is that many prospectuses at least mention derivatives and leverage today. We took a look at filings for several of the largest bond funds, for example, and found that almost every prospectus contained language explaining something about the potential risk that their use of derivatives could produce leverage. It's boilerplate stuff that most people gloss over, but at least it's there. And in general, it seems that there are some fund companies at least making more of an effort to inform their investors. We took a look at a handful of them in a recent column.

What we don't often see, however, is much--or any--mention of leverage or derivatives in funds' periodic portfolio reports, fact sheets, or marketing materials. Of course, most fund companies don't want to write anything that they think will spook investors, and there are certainly valid uses for derivatives that don't dramatically increase funds' risk profiles. Even in such cases, though, it's disturbing to look at funds that make generous use of derivatives but that choose not to explain them. In the grand scheme, a little more text isn't going to stop fund managers from making mistakes, but it could go a long way toward making sure that investors better understand the potential risks of what they own.

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Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.
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