Morningstar Magazine - August/September 2018 - 10

Dispatches

The Fund World's
Achilles' Heel
Most of the industry's
worst moments involve
fixed-income funds.
PHILLIPS CURVE

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.

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.

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.

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.

Don Phillips

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

Morningstar August/September 2018

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

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. K
Don Phillips is a managing director with Morningstar. He is
a member of the editorial board of Morningstar magazine.

Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2018