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Rekenthaler Report

The SEC Targets Bond Funds

And it's about time.

Curing the Common Cold
This past Thursday, SEC Chair Mary Jo White summarized the commission's current mutual fund initiatives. All primarily involve bond funds. Key items:

1) Standardized reporting of derivatives

Naturally, the Investment Company Act of 1940 did not envision derivative securities. Although reporting rules have changed along with the times, they have not yet caught up with derivatives. Different funds can and do report the same positions in different ways, thereby destroying comparability. Worse, some funds omit critical information, so that an outside party cannot determine true risk exposures.

The SEC wishes to change that. The commission wants the Schedule of Investments to be so detailed and standardized that investors can find fund holdings, including derivatives positions, via Internet searches. That goal strikes me as highly optimistic--particularly for custom derivatives--but I do salute the SEC's intention.

(There is a second aspect to derivatives reporting that the SEC is not pursuing. Even if each individual derivative is consistently and thoroughly listed, shareholders cannot interpret the portfolio results without a great deal of additional labor. Nobody this side of professional bond managers--perhaps not even them--can look at a long string of derivative positions and envision how those hedges and counterhedges all play out.

In short, funds should summarize their risk exposures, including the effects of both their underlying holdings and their derivatives overlays, so that shareholders can see the net results: the fund's currency exposure, interest-rate risk (duration), credit weightings, and so on. Such a report would be difficult to make completely consistent across funds, given that some inputs are estimates, but for me the occasional lack of comparability would be worth the effort. After all, portfolio managers demand such a report when running a fund. Why not give shareholders what management sees?)

2) Standardized reporting of securities lending

According to the SEC, about 25% of mutual funds conduct some form of securities lending, receiving interest payments for making their portfolio holdings available to borrowers. Securities lending currently befuddles both shareholders and the commission itself. The commission would like to put the strategy in the open.

It makes sense for each party, but in different ways. The SEC's main interest lies with tracking systemic risk. The issue for fund shareholders, in contrast, is fees. Today, some fund companies pocket part of their securities-lending income rather than pass the whole amount along to shareholders--a dubious practice, as the investment risk that arises from the lending activity is entirely the shareholders'. The bright light of disclosure would likely change that habit.

3) Stress testing of portfolios, particularly for liquidity

The SEC realizes that most mutual fund disasters follow the same pattern. A bond fund looks too good to be true, in that it has significantly higher yields and lower volatility than the competition. That bond fund swells in size because of its charms. Eventually, it encounters an unfavorable market, drops in price, and scares off the most skittish of its owners. To meet redemptions, the fund's portfolio manager must sell into weakness, thereby pushing down the price of the security, realizing a loss, and sending the net asset value into further decline. The next batch of investors redeems, forcing the fund to sell more securities, at a greater loss. Rinse, wash, repeat.

The higher yields and lower volatility are both associated with an illiquid portfolio. The funds' bonds pay extra income so as to compensate their owners for the difficulty of trading them. They have been less volatile not because they are inherently safer, but rather because they do not often trade, so their prices are "sticky," which is Wall Street lingo meaning "inaccurate." Schwab YieldPlus Fund was the most infamous example of such behavior, shedding 30% of its value and nearly all of its owners over an 18-month stretch during 2007-08. There have been plenty of others.

The SEC has not yet decided how to prevent future liquidity bombs, but it does seek to fix the problem. Possible solutions include stress testing the effects of sudden redemption requests; creating tougher liquidity standards for bond funds (perhaps akin to the recent changes with money market funds, which are now required to hold a certain percentage of their assets in easily tradable securities); and/or requiring that funds measure and disclose their liquidity risks.

4) Transition planning

No doubt with the example of Reserve Primary Fund's 2008 collapse firmly in mind, the SEC is "developing a recommendation to require investment advisers to create transition plans to prepare for a major disruption in their business." (By "investment adviser" the SEC means asset-management firm; the assets might be registered funds, or they might be in another form, such as separate accounts.)

This puzzled me at first, but then I realized that it appears to be an extension of the liquidity concern. The SEC is worried about asset managers that go belly-up. Perhaps their companies declare bankruptcy, or perhaps they are seized by regulators. Either way, there is the potential for market disruption--as Reserve Primary Fund's implosion roiled the money market business in September 2008. The commission would like to anticipate such disruption as best as it can.

Addressing Future(s) Problems
The SEC's recommendations admirably address the last war. I mean no insult by that, because the 2008 war wasn't a singular event; rather, it was the most recent in a series of embarrassments by bond funds, sometimes (although not mostly) because of derivatives exposure and almost always exacerbated by a lack of liquidity. Bond funds, not stock funds, have been the industry's problem--and the SEC is taking key steps to prevent the danger.

The next war, surely, will come with alternatives funds. Not only do many alternatives funds share with bond funds the habit of having complex, derivative-laden strategies that can be difficult to trade during a crisis, but they also offer several new challenges.

For example, Morningstar's Jason Kephart mentions total-return swap agreements in managed-futures funds that have "zero look-through." The fund receives something from its swap, but the portfolio doesn't disclose what that something is, nor the associated fees. Rules that apply to conventional stock-and-bond portfolios do not necessarily address all the issues of alternative funds. The different structure, after all, is one reason that such funds are called "alternative."

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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