No Happy Holidays for Shareholders of These Funds

With many markets having rallied like crazy since March, this holiday season likely feels far more enjoyable for investors than last year's did. The fact that most equity funds aren't paying out taxable capital gains distributions this year adds to the feeling of relief.

But not everyone is sharing in the joy. Here are two funds whose shareholders won't be able to swap success stories around the fireplace in the coming weeks.

When Safe Isn't Safe
As I noted in a column a few months ago, the concepts of "safe" and "risky" can be misleading. Depending on when and how you buy them, even U.S. Treasury securities can be risky plays. Shareholders of Vanguard Extended Duration Treasury Index (VEDTX) learned that the hard way in 2009. In a year when nearly all stock funds have posted hefty gains and several categories of bond funds boast average returns greater than 20%, this fund has suffered a shocking 35.4% loss through Dec. 10.

How is that possible? If you remember, in late 2008 panic in the markets sent many worried investors flooding into U.S. Treasuries in search of something--anything--that was unlikely to go to zero. As a result, prices of these securities soared. Then in 2009, these prices fell back in a hurry. Even though many questions remained about the strength of the world's economies and financial institutions, the feelings of abject panic subsided as government support programs expanded. As a result, many investors shifted out of the ostensibly safe havens to which they had fled.

Funds that owned the longest-term Treasuries were hit hardest by this reversal. But the Vanguard fund, which invests largely in Treasury "strips" that react even more strongly to such moves than conventional Treasuries do, suffered the biggest loss among the small contingent of long-term government funds.

To add to the pain, shareholders slammed by this monster loss will receive taxable capital gains distributions from their fund this year. That odd situation owes to the immense gains earned by the fund in 2008. As explained in the fund's annual report, some shareholders withdrew their money in 2009, and the fund had to sell holdings to generate cash. It realized gains as a result. Those shareholders remaining in the fund are stuck with the tax bill. (The shareholders who took their gains and ran may not emerge scot-free. If they held those shares in a taxable account, they're liable for taxes on their own gain.)

Shareholders can't say they weren't warned. The "President's Letter" included in the annual report of Aug. 31, 2009, specifically alerted shareholders to expect a "sizable" capital gains distribution in December.

In fact, this news could have been worse. Vanguard Extended Duration Treasury is not aimed at retail investors, so it's unlikely that ordinary Joes felt the brunt of this double-whammy. The fund has a steep minimum and is designed to be used as one part of a broad, complex strategy by pension-fund managers. Such managers probably aren't thrilled with a 35% loss, either, but at least they were likely to know exactly what was entailed in this fund's strategy, and to have owned a variety of other assets that performed far better this year. Depending on the circumstances, they may not have to pay taxes on the distribution, either.

Off Balance
In 2008,  Oppenheimer Core Bond (OPIGX) made headlines. For bond funds, that's usually not a good thing. The fund's then-managers made bold choices that went very wrong during chaotic market conditions. The fund's prominence in certain states' college-savings plans attracted widespread notice and criticism.

The damage was not limited to that fund. The fixed-income side of  Oppenheimer Balanced  was run by the same managers who ran Oppenheimer Core Bond. That explains how Oppenheimer Balanced could have lost 42% in 2008--a staggering toll for a balanced fund, considering that an all-stock portfolio mirroring the S&P 500 Index would have lost "only" 37%.

In 2009, though, the managers that had steered Oppenheimer Core Bond into the rocks were gone. So were their most-aggressive positions, having been jettisoned by a transitional management group that ran the fund over the winter before a new team was installed. The new team, using a more-cautious strategy rather than the troubled 2008 approach, took over Oppenheimer Balanced's bond portion as well. 

In one sense, 2009's results have been happier: Instead of suffering a huge loss, Oppenheimer Balanced is up 18.3% for the year to date. Unfortunately for shareholders, that means another year of underperformance. The fund's 2009 return sits in the bottom quartile of the moderate-allocation category.

What went wrong this year? For one thing, this fund's more-conservative bond stance turned out to be at odds with market sentiment. In early 2009 fixed-income investors around the world breathed a sigh of relief and suddenly turned adventurous again. That held back this fund's performance in relative terms.

Moreover, in 2009, the Balanced fund's stock side has had issues of its own. The manager of the stock portfolio has an eclectic style that's recently leaned heavily on technology stocks. Over the years that approach has worked well at this fund and at a sibling with a more flexible strategy. In 2009, though, it has had less success. One problem: On December 4, this fund's top holding, software maker  Take-Two Interactive (TTWO), plunged 29% after a disappointing earnings announcement. (At the end of October, that stock took up 3.9% of the Balanced fund's portfolio.) The fund's performance that day scraped the bottom of its category. A larger-than-average cash stake has also held the fund back this year.

Oppenheimer Balanced could have been hurt even worse by Take-Two Interactive's slide had it not been actively trimming its position much of the year. At the end of June 2009--after the trimming had already begun--that stock still had made up more than 5% of the portfolio. Further selling brought the position down to that 3.9% level by October's end. Whatever the December 4 level was--that information isn't public yet--it's unlikely the amount was as high as it had been earlier in the year.

Learning Opportunity
As usual, these unpleasant stories yield lessons. Even if retail investors weren't directly affected by the Vanguard Extended Duration Treasury loss, for example, it does demonstrate very clearly the dangers in assuming a security is worry-free just because it comes from the U.S. government. (And in fact, some ordinary investors might have owned the fund, for it offers ETF shares that, like all ETFs, have no minimum investment.) The Vanguard fund's story also shows (if further proof were necessary) that something that goes way up--this fund soared 55% in 2008--can also. . . well, you know the rest.

Meanwhile, the Oppenheimer Balanced saga demonstrates the importance of investigating a fund's portfolio and characteristics closely. While the Vanguard fund's name hinted at the risks involved, this one's did not. A balanced fund seems like a moderate choice. A more conservative bond strategy seems wise. But there's always more to the story.