The Fund World’s Achilles' Heel
Most of the industry’s worst moments involve fixed-income funds.
Fixed-income funds have not grabbed many headlines in recent years, and that’s a very good thing. When bond funds make big news, it almost always portends bad things for investors.
In recent years, the news has been limited to steamy, but largely incidental issues, such as egos causing managers and their shops to part ways, forcing investors to choose sides. While such moves can have tax consequences, for the most part these divorces are more painful for the parties involved than for fund shareholders. Of greater concern is when bond funds make headlines for their innovations or their asset growth, something we have seen too often over the past 30 years.
Think back to when PaineWebber Short-Term U.S. Government Bond Fund was hailed as the future of the fund industry as it was among the first of the then-new C share mutual funds. The fund gobbled up money as brokers, lured by a rich trail commission, shifted client assets from money market funds into this short-term bond vehicle.
The fund’s managers were boxed in. They were pressured to keep the fund’s yield above that of a money market fund, but they were hampered by the higher costs of the fund’s 12b-1 fee, which paid for the trail commission that was bringing in the cash. The fund’s short-term and U.S. government mandates further constrained the managers. Predictably, they turned to derivative securities to boost yield, and equally predictably, the experiment failed. The fund suffered losses that shocked shareholders who expected stability from what many considered to be the cashlike portion of their portfolio. Similar ugly stories were acted out with Alliance Short-Term Multi-Market, Schwab Yield Plus, and too many others.
The root of the problem is that bond-fund managers and bond-fund shareholders often have very different mindsets. Managers generally focus on relative performance and total return. Shareholders too often focus on absolute measures like a threshold 5% or 10% yield. When marketers get between investors and managers and pressure managers to inflate yield, trouble follows.
Consider the infamous Dean Witter High-Yield Bond Fund, the yield king of the mid-1980s. It was sold through Dean Witter’s aggressive salesforce and even out of kiosks in Sears stores! Shoppers wandering in for a Craftsman wrench were enticed by how much higher the fund’s yield was than those of passbook savings accounts. The fund quickly became one of the largest in the United States. Then, the high-yield market collapsed, sending the fund to a loss of more than 30%—quite a shock for investors expecting safety.
A less disastrous, but still ugly, sequence played out with so-called “government-plus” funds. These appealed to investors who had embraced money market funds in the early 1980s, when yields reached double digits. When yields fell below that magic 10% level, investors sought ways to keep the party going, and the fund industry was ready to provide the punch. Although longterm bonds have far more interest-rate exposure than money market instruments, the industry stressed the stability of U.S. government bonds, festooning their ads and shareholder reports with American flags. Government-bond funds became among the industry’s best-selling offerings.
Then, long-term bond yields dipped below 10%. The industry responded with governmentplus funds that wrote covered calls to generate short-term capital gains that could be used to inflate the funds’ “yield” in the eyes of less-knowing investors. Eventually, bond yields fell so much that these option-writing practices could no longer generate enough gains to maintain the desired 10% payouts. Fund companies responded by supplementing the monthly payouts with return of capital distributions. Thus, investors were paying loads to get into funds that were in part just giving them back their own capital—hardly the industry’s finest moment.
Other bond-fund shenanigans were exposed when the peso crisis reminded investors that “North American government” in a fund’s name essentially meant “Mexico.” Similarly, the financial crisis showed how two “U.S. government” funds could be doing completely different things, causing one to drop nearly 40% while another suffered only minor losses. Such disasters have tarnished even some of the industry’s oldest and more respected shops like Schwab, Putnam, and Oppenheimer.
As a result, many financial advisors have shied away in recent years from making fixed-income bets. Assets have been directed to the bigger, more established shops, and investors have settled for the paltry yields available in today’s market. Indeed, most advisors I know have been urging clients to keep maturities short, and have been doing so for upward of a decade— a rather significant misplaced bet, but one that hasn’t burned up capital. For most clients, opportunity costs are preferable to outright losses. Instead, raising yield by lowering costs has been the sensible rallying cry of recent years.
This is a temporary reprieve: Rising yields will give funds greater ability to lure gullible investors. Some shareholders will fail to grasp the potential for capital loss—and react violently when they see losses where they expected stability. Fund marketers will be tempted to gain market share by appealing to investors’ baser instincts, even though those quickly won assets may put their firms’ reputations at risk. Investors and their advocates—regulators, analysts, the press, and financial advisors—must remain ever vigilant. Fixed income remains investors’ and, by extension, the industry’s point of maximum vulnerability. When it comes to bond funds, winning doesn’t mean generating the biggest gains; it means keeping client nest eggs and the industry’s reputation intact.
This article originally appeared in the August/September 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.