Morningstar Advisor - April/May 2009 - 33

appetites, there’s reason to believe a number of them in each area took on more risk than shareholders expected. Unfortunately, it can be a difficult task for investors to uncover these nuggets of truth in portfolios. (See “Guide to Finding Hidden Risks” on page 36.) It’s possible for two different approaches to look extremely similar: One fund may carry economic exposure to credit markets of twice its net assets, while the other does not when all of its offsetting exposures are properly recognized. Simply finding the information in fund company reports is a challenge. Futures, interest-rate swaps, total-return swaps, credit default swaps, forward contracts, options, swaptions, and any number of other derivatives are typically buried in portfolio footnotes and endnotes, some of which are ambiguous or useless. An Everyday Disaster of “primarily,” but eight pages after the fund’s Schedule of Investments, there appears a list of 15 credit default swap contracts—every one of them generating long credit exposure—with a notional value of nearly $210 million. That number packs a punch given that the portfolio contained only $418 million in net assets at the time. In other words, those swaps didn’t themselves add to the fund’s interest-rate risk, but they made the fund roughly 150% exposed to credit- and mortgage-market movements not otherwise accounted for by interest-rate shifts. Those exposures had been cut in half by the end of October, so it’s possible that the fund’s managers headed off even worse trouble, and they did benefit from a stake in long Treasury futures. The bottom line, however, is that the fund lost 10 percentage points more than its average intermediate-term bond peer for the year. You Ain’t Seen Nothin’ Yet allowed the contracts to expire before the sector imploded in the fourth quarter. There were extremely large exposures to a menagerie of off-balance-sheet interest-rate and credit default swaps as well, both long and short. By the time the market was deep into its autumn implosion, the fund’s leverage had ballooned, and its total balance-sheet market exposure (cash-adjusted) was roughly 230% of its net assets at the end of October. The fund lost “only” 20.3% in 2008, which still left it more than 25 percentage points behind the Barclays Capital U.S. Aggregate Bond Index. The Center of the Storm Then, there are those cases that approach catastrophe. In mid-December, Oppenheimer’s lead taxable-bond fund manager, Angelo Manioudakis, abruptly left the firm. It’s not hard to see why Manioudakis threw in the towel. As a result of the risks being taken by Oppenheimer managers, 22 of the firm’s 25 bond funds lost more than 10% in 2008. Two of the most jarring losses occurred at funds run by Manioudakis: Oppenheimer Core Bond OPIGX, which lost 36% for the year, and Oppenheimer Champion Income OPCHX, a high-yield fund that plummeted an unthinkable 79%. At first blush, the cause of these funds’ demise seems logical. In January 2008, Manioudakis and his team built positions in four areas that would get pummeled later in the year: AAA rated commercial mortgage-backed securities, nonagency prime (jumbo) mortgages, AA and A rated financial-sector corporate bonds, and very short-maturity high-yield corporates. But something just didn’t add up. In January 2008, Manioudakis told Morningstar that CMBS consumed 10% of the Core Bond’s “absolute market value.” As badly as the sector performed—the Barclays CMBS Index fell 27.4%—that alone couldn’t possibly explain the portfolio’s overall loss of 36%. Ditto for the other sectors, even though they lost a lot, as well. A mere handful of those tools can alone alter the entire economic exposure of a portfolio. Take the relatively modest example of AIM Income AMIFX. The fund tumbled 15.3% in 2008—its worst performance since 1969. But that result wasn’t anywhere near the worst showing of a bond fund. Explanations in the fund’s fourth-quarter update about poorly performing mortgages and allocations to a suffering high-yield bond sector appeared reasonable on the surface. There’s more to the story, however. The shareholder letter in AIM Income’s July 2008 annual report gave at least one clue that the fund had taken on atypical risk, but then essentially dismissed it in the same breath. The letter noted that the fund “sold a credit protection swap to generate additional portfolio income.” The letter also said that the fund maintained an overweight to the investment-grade corporate-bond market “by investing primarily in actual bonds.” It may be that the fund actually sold only one new swap during the period, and there may be a legally defensible way to explain the meaning There are funds that endured more damage than did AIM Income. One was Putnam Income PINCX., which was exposed to breathtaking levels of risk. Putnam’s managers didn’t look at it that way, however, because they were relying on historical data to target risk levels commensurate with the returns that they were seeking, and those risk levels did not stand out to them. Yet some portfolio digging turned up an alphabet soup of mortgage securities, many of which were potentially volatile derivatives. The fund’s Schedule of Investments listed sector weightings that added up to nearly twice the fund’s total net assets. (Subtracting approximately 20% in cashlike securities implied the fund had 175% in market exposure.) That didn’t create a sufficient level of risk to satisfy the fund’s models, however. In addition to commercial mortgage-backed securities, the fund also held a variety of off-balancesheet total-return swaps. These formed a truly massive exposure in early 2008. Fortunately, the managers either reduced the position or MorningstarAdvisor.com 33

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Morningstar Advisor - April/May 2009

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