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Fund Spy

The Still-Sorry State of Bond-Fund Disclosure

It's five years after the crisis, and bond funds still badly need to improve how they tell shareholders what they own.

A version of this column originally appeared on Morningstar.com in August 2009. 

On any given day, you might find Morningstar analysts sifting through pages of bond-fund reports and factless "fact sheets" trying to grasp a manager's strategy or what kind of market exposure a fund has. Forget about the shareholder letter providing anything useful. If you're lucky you might learn a little about why the fund performed the way it did during a six-month period that ended two months ago. But detailed explanations of a fund's market bets, or what's driving a manager to make them, are often few and far between.

We've been fortunate to benefit from a long-term industry shift toward providing more detailed data to institutional investors and firms that work with them. The opacity of most regular bond-fund disclosures, however, makes them nearly useless to the average shareholder.

There is a lot of important information in those reports, and there's much more today than there used to be. But if you really want to know how and why a fund is positioned the way it is and what market risks it has, those materials are often woefully inadequate. Delving into the holdings of a bond fund, meanwhile, is orders of magnitude more difficult than doing so for a typical stock fund. The reasons are many, but the most basic is just the availability of data and information. Those are almost universally available on the Internet for exchange-traded stocks, which in the U.S. number in the tens of thousands, a relatively manageable figure for almost any data or research provider. Depending on what you include, that figure could approach 10 million for the number of individual bonds. Unless you've got the analytical and data firepower to sift through and compare a fund's holdings against that entire universe--capabilities possessed by only a very small handful of Wall Street's largest firms--the only place to get useful information is from fund companies themselves.

This is not a conspiratorial plot, though. There are cases here and there in which shareholders seem to be deliberately left in the dark, but most of the time the explanation is more banal. Big shops with scores of funds have to turn out an array of materials at regular intervals for regulators, internal and external salesforces, and, of course, shareholders. That may require an entire operation with staffs to work on accounting, writing, design, and legal compliance. In that world, standardization and consistency are prized. Detailed charts, graphs, and tables that require manual adjustment and frequent changes are anathema to the smooth running of that paperwork machine.

There may have been a time when grudging acceptance of that state of affairs seemed reasonable. If so, it ended when the financial crisis triggered shocking losses in some corners of the bond market, confounding fund investors who had no idea they were exposed to such risks. It has already been more than five years since the crisis subsided, though, and it's anybody's guess as to when the next big stretch of trouble will come, even if it's not a 2008-style event. The Wall Street Journal recently reported that the SEC is working on beefing up mutual fund disclosures (subscription required). That effort must include bond funds, and it can't come too soon.

A comprehensive wish list of disclosure reforms would run much longer, but here is a snapshot of five essentials.

1) Tell shareholders if their funds are leveraged.
Years ago, finding an open-end mutual fund with leverage was like finding a needle in a haystack. Today, they're a dime a dozen, but you have to know how to find them. You can learn how leveraged a fund is by digging deep into its financial disclosures, but good luck finding reference to it anywhere else, whether it's in your shareholder letter, on a fact sheet, or in an asset breakdown. Given the amount of added risk that leverage can produce, that's infuriating. At some point, omission crosses over into deception, whether truly deliberate or not.

2) Tell shareholders if their funds are leveraged--continued.
Even if a fund hasn't actually gone out and borrowed money to create leverage, it can create leveraged exposures with derivatives. We found several that did so in 2008 without providing any meaningful explanation to shareholders. The futures and swaps creating those exposures were detailed deep in each fund's financial statements, but the information was almost universally more difficult to find than conventional leverage and just as absent from the graphs, tables, and shareholder letters one might otherwise rely on to understand a portfolio. Things are scarcely much better now, but at the moment anyway, there are almost certainly fewer funds taking on risks as big as they did leading up to the crisis. That will almost certainly change as the pendulum swings back, though, and the industry needs to be ready.

3) Provide an asset breakdown that's actually meaningful.
The "correct" way to do this often depends on the kind of fund, but that's the point. A generic sector breakdown that sorts a portfolio into buckets like Treasury bonds, corporate bonds, and mortgages is nearly useless if the mortgage bucket comprises 50% of the fund and houses a mix of current-coupon Ginnie Mae pass-throughs, prepayment protected CMO tranches, a hunk of subprime paper, and manufactured housing debt, just as an example. The chart for a national muni fund that breaks down by state is equally useless if it's chock-full of tobacco settlement, airline, and nonrated nursing home bonds.

4) Don't make me do the math or send out a search party for the number.
It's when a fund report has 15 pages of credit default swaps and no tally of the market exposure they represent that you start wondering whether someone really is trying to hide something. Ditto if they're not factored into a fund's credit quality and corporate-sector exposure. Arguably the worst number-formatting sleight-of-hand we've seen is the presentation of a fund's total investments with no reconciliation to net assets. In other words, no line item breaking out how many of those assets are borrowed (that is, leverage) and how many are truly "net" assets. That's one number that has no business whatsoever being relegated to a footnote.

5) Tell me what my manager would want to know.
This is the guts of it, and just an adaptation of Morningstar investment consultant Mike Stout's First Rule of Fund Analysis: What would you tell your mother? The manager of every fund is the one person who knows best what information you need in order to understand its strategy, what its market exposures are, and what kinds of risks it's taking. Many managers don't even realize that the information in a typical annual report doesn't come close. In fact, most of them use software packages and tracking systems that look at their funds through completely different lenses than those in public disclosures. Bottom line: If it's not good enough for the fund manager, then it's definitely not good enough for his boss. You know, the one that actually owns the fund.