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Fund Spy

Bond Funds Swimming Naked -- Page 3

The water receded in 2008 and some of what was revealed isn't pretty.

Silence of the Wolves
This combination of outsized risks, a dearth of more candid shareholder communication, and, in several cases, a failure to discuss relevant issues with analysts, is troubling to say the least. And it has happened at numerous firms. Although we regularly and systematically examine the data provided by fund firms, we've long had to rely on the candor of bond managers to effectively decipher their strategies, tactics, and overall portfolio exposures. Unlike equity mutual fund portfolios, analyzing and measuring security-level and portfolio information has always been maddeningly complex on the bond side. Even in the case of relatively simple bond portfolios, it can be tricky to draw too many conclusions about the information one cobbles together from portfolio disclosures. We therefore expect that our analysts' interviews with fund managers will fill in many of the gaps. And frankly, we expect that unquestionably material fund characteristics such as leverage will be brought up--loud and clear--in response to simple questions like "Is there anything else about your portfolio that you think is important for us to know?" Too often, they weren't.

A Stunning Failure of Stewardship
The breadth and depth of these informational omissions is nothing short of astounding. It's a sad turn of events for the industry, which has been a leader in transparency when compared with many others.

A number of managers simply made poor decisions at a sector level. And there are reasons it's difficult to discern among the forces of deliberate intent, benign neglect, and poor judgment when it comes to the decisions that they made. Make no mistake, though: A considerable number of managers and fund companies appear to have badly failed their investors in terms of both basic management and stewardship.

That's All Well and Good for Sheep
What should you do if you're concerned about your own fund? If you're a Morningstar Premium Member, check to see whether our Analyst Reports have highlighted risks of this type. (We have already shared warnings about risk in many cases, even if fund companies hadn't disclosed greater detail to us during our regular interviews.) Then look through your annual or semiannual shareholder reports. If you've thrown them out, don't worry. The most recent reports are almost always available for free on fund company Web sites, or from our fund quote pages on under the left-side tab marked "SEC Filings." If you want to look back even further, you should be able to track down older filings at the SEC's EDGAR Web site.

It may not interest you to read these in great detail. As far as we're concerned, though, anything in a fund's portfolio that isn't adequately explained in its reports is a shortcoming. In particular, if you find scads of the aforementioned derivatives, such as inverse floaters and swaps, whose use and performance aren't clearly explained, we would suggest picking up the phone and calling your fund company. Many representatives won't be trained in the finer points of these securities, but there should be someone at every firm who can help you understand more about how much risk your fund is or isn't taking. If you use a financial intermediary such as a broker or fee-based planner, that person may be able to help you navigate the fund-company waters and get answers to your questions.

What we've found here is especially disappointing given the great strides bond fund managers have made in the past 20 years. Once the domain of run-and-gun hotshots who made big bets in an effort to juice portfolio yields and seize the interest of salespeople, the universe of so-called "retail" bond funds sold to individual investors has become increasingly reflective and thoughtful, adopting many of the institutional world's best practices.

Unfortunately, it looks as though in many such cases managers found themselves emulating the sophisticated tools and strategies of the industry's marquee names, without sharing those players' comprehensive understanding of risk--or their skills.

Mutual fund analyst Miriam Sjoblom contributed to this article.

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Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.