Why Mutual Fund Guardians Are Failing

Thanks to Will for passing this along.

When Charles Schwab's popular YieldPlus bond fund started to tank during the financial meltdown, the fund's problems went beyond the queasy markets. YieldPlus, according to the fund's prospectus, was designed to offer "high current income with minimal changes in share price." That didn't turn out to be the case in 2008, when the fund's net asset value plummeted more than 35 percent, some four and a half times what short-term bond funds lost as a whole. Nor was it true in 2009, when shares of the once-stable fund tumbled another 11 percent.

Apart from the obvious financial turmoil of the times, however, there were an array of hidden reasons for the fund's sudden fall. In public disclosures, YieldPlus's managers had said the weighted average maturity of the bonds the fund held was six months, a mark of safety; the Securities and Exchange Commission later said the average reached as high as 2.2 years. As a result, when the broader market imploded, the fund was forced to unload its holdings at fire-sale prices, leading to deeper losses. YieldPlus's registration statement said the managers would not place more than 25 percent of assets in certain types of securities, at least not without explicit shareholder approval. But not long before the market went into free fall, managers stuffed about 50 percent of its portfolio with nongovernment mortgage bonds, the SEC said in a January 2011 cease-and-desist order. And during the crisis, when investors and brokers asked if redemptions were draining the fund, Schwab's lead portfolio manager said in a conference call, "We've got very, very, very slight negative flows," according to the SEC. In fact, the fund had hemorrhaged more than $1 billion in the preceding two weeks.

In the end, Schwab, without admitting or denying wrongdoing, would agree to pay $119 million to settle SEC civil charges that it misled investors; the company also paid $235 million to settle a private case brought by investors. Schwab, saying it was constrained by the settlement terms, declined to comment on the matter. Last year, though, it attributed the fund's losses to an "unforeseeable credit crisis" and said it "would never seek to profit at the expense of its clients."

But while the YieldPlus incident may have directly affected the shareholders of just one Schwab fund, it shines a rare spotlight on something that could well affect any investor in the roughly 7,700 portfolios in the $12 trillion mutual fund industry -- where a quarter of American household assets are now kept. In the case of YieldPlus, say some critics, an important if little-known layer of investor protection failed. This safeguard did not involve a government agency or an outside auditor, but an internal group of highly paid overseers: the fund's own board of trustees. The lapses in oversight that occurred with YieldPlus, experts say, are part of a system of fund governance that is almost designed to fail. "The real puzzle isn't why these safeguards don't work," says John Morley, a University of Virginia Law School professor who has studied the issue extensively. "It's why anybody thinks they could work."