Mutual Funds and Risk Management

Reprimanded! Last week, the SEC settled an action it had filed against Catalyst Capital Advisors for misrepresenting the risk of one of its mutual funds, Catalyst Hedged Futures Strategy. (On the day of the announcement, the fund changed its name to Catalyst/Warrington Strategic Program HFXAX. A culprit protection scheme!)

In its official documents, the fund had presented itself as being for conservative shareholders, citing a goal of "capital preservation in all market conditions," supported by "strict risk-management procedures." Informally, the fund's management went further, telling investors that the fund's potential losses shouldn't exceed 8% because of its investment safeguards. In fact, claims the commission, "no such safeguards existed."

In early 2017, the fund shed 20% of its value, which indicates that either the SEC's contention is correct, or the risk-management strategy was woefully inadequate. As the fund was large at the time, that percentage decline translated to more than several hundred million dollars of shareholder losses.

Lessons Learned The case is thrice instructive:

1) Promises about risk management made outside the prospectus aren't worth much. I mean that sentence literally. The fund lost almost $400 million more that it would have had its sell-off been limited to 8%. However, the final settlement was but $10.5 million. Some of that difference owes to the bargaining process; save the SEC the trouble of going to court, and it will reciprocate by lowering the fine. But clearly, the commission didn't treat the 8% promise as fully binding, by making the fund company responsible for the balance. Instead, it settled for two and a half cents on the dollar.

If the SEC doesn't regard ancillary material--in Catalyst Hedged Futures' case, marketing brochures and management statements--as being fully binding, why should investors? The claims can never be verified. No outsider possesses the information required to test if a mutual fund can deliver on its risk-management assertions. Doing so would require daily portfolios, while mutual funds at most provide monthly positions.

The declarations must be taken on solely on trust, which is no way to invest. To be sure, most fund companies intend to deliver on their words, and their businesses will suffer if they do not, regardless of the legal implications. Their funds will likely behave as purported. But I would not stake my money on that.

2) Promises about risk management made inside the prospectus aren't worth much. These declarations carry more potential bite. The problem is that they are vague. What does it mean, exactly, for a fund to state that among its goals is capital preservation? The proposition is effectively untestable. If the fund fares well, growing its capital, it might have been poorly managed but buoyed by favorable markets. If it drops sharply, did it violate its charter? Probably not. After all, a goal is not a promise.

I can't think of many cases over the years where fund companies have been challenged by the SEC for incorrectly stating their risks. For owning impermissible securities, for mispricing holdings, for allocating expenses incorrectly … those infractions come to mind. But rarely for violating their risk decrees.

3) Track records don't indicate much about risk management Three years ago, I wrote this about Catalyst Hedged Futures:

The fund lost 15% in a week. Should investors have known that such a drop was possible? There was nothing in the fund's postconversion record [that is, after it converted from a hedge fund into a mutual fund]. It became a mutual fund in summer 2013 and had performed smoothly since that time. There was also nothing in the fund's preconversion history, save for a one-month period shortly after its late-2005 inception, when the fund fell 18%, albeit over four months rather than one. Was that 2006 decline a clue as to what befell the fund 11 years later? Or was it a nonrepeatable event, a product of the fund's small asset base and/or a more aggressive strategy?

By now, you may be sensing a theme. When funds use complex strategies, such as trading various futures contracts, as opposed to buying asset classes, as with U.S. equity funds, balanced funds, or government-bond funds, shareholders are left guessing. Admittedly, they don't know how asset classes will perform--but they do have a good sense of how their funds will behave, given that performance. With complex strategies, they do not. There is always the possibility of event risk.

Investment Thoughts I would not purchase such a fund. Not only do I wish to avoid event risk, but I distrust risk-management strategies as a general principle. They force funds to become more conservative as their holdings decline in price, which displeases my contrarian instincts. Also, downside-protection tactics sometimes suffer ripple effects, as with portfolio insurance in 1987, when too much money crowded into too few trades. They are less predictable than their practitioners believe.

If one must own funds that employ opaque risk-management techniques, best to think big for providers and small for allocations. Prefer the major fund companies to boutique providers. The giants have so very much to lose should they err. They will be cautious about their promises; careful about meeting them; and if worse comes to worse, may reimburse shareholders for mistakes with their own monies, to preserve their reputation. And buy sparingly. If event risk does strike, ensure that the damage is minor.

Better yet, own a diversified alternative fund, rather than one that follows a single approach. The funds in the multialternative Morningstar Category are the investment equivalent of the Titanic's watertight compartments, which were designed to prevent a leak in one area from spreading to the next. The Titanic's construction failed, but the multialternative funds' design appears to be sound.

This column began with an investment manager's promise to limit investment losses. It will end with the contention that the best way to achieve that goal is to avoid funds that make such promises. Seek greater diversification instead.

Coda Last July, I wrote about a paper by Morningstar's James Xiong and Tom Idzorek called "Quantifying the Skewness Loss of Diversification." It turns out that the paper was a finalist for the Journal of Investment Management's annual Harry M. Markowitz Award, receiving a merit for "Special Distinction." Well done!

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.