August 21, 2008
By Emily Lambert
Forbes Magazine
James Lyle, 56, fought fires in Auburn, Ala. until a disability sent him into retirement 14 years ago. Looking for a safe place to park his cash, he put $65,000 into the Morgan Keegan Select Intermediate short-term bond fund in 2006. Fund sales literature promised “capital preservation and income” and “greater stability in principal value than that of long-term bonds.”
All went well until the mortgage market began melting down last summer. To eke out high yields, Select Intermediate had invested heavily in collateralized mortgage obligations and other housing-related paper, which tanked. The fund’s share price has fallen from $9.60 a year ago to 97 cents. Lyle invested in two similar Morgan Keegan funds promoted as safe fixed-income investments that suffered similar fates, bringing his total losses to $150,000, representing 35% of his net worth.
“I was lied to,” says Lyle, who blames Morgan Keegan but not his broker. “Especially when I bought in, my broker was telling me exactly what is in print.”
Lyle has plenty of company. Retirees Martha and Aubrey Wright of Marietta, Ga. have lost 68% of their investment, or $109,000, in such Morgan Keegan funds. They’ve returned to work and cut back on prescription medication to make ends meet. Vincent McCormack, 71, and his wife, Marie, lost $558,000, which is 90% of their investment and close to a third of their retirement savings.
All of these investors have accused Morgan Keegan of fraud in claims filed with the Financial Industry Regulatory Authority (Finra). Morgan Keegan declines comment.
The mutual fund universe has 6,700 funds competing for attention, not counting money markets. They garner it by running glossy ads and distributing spiffy sales literature to brokers and financial planners. To the industry, it’s all about one thing: gathering assets to generate fee income.
Unfortunately, the safety net that’s supposed to protect mutual fund investors from efforts to do this with false and misleading promotions is full of holes. It always has been.
In the late 1980s and early 1990s adjustable-rate mortgage funds were touted as higher-yielding proxies for money market funds. By 1992, 37 had sucked in $20 billion–just in time to collapse along with the real estate market, as industry scold (and Vanguard founder) John Bogle recounts in his book Common Sense on Mutual Funds (John Wiley & Sons, 1999). Most then either closed or changed their names and objectives.
Piper Jaffray (nyse: PJC – news – people ) paid $67 million 13 years ago to settle a class action after a fund it had promoted as a safe place to park cash lost 30% of its value. It, too, was loaded with mortgage-backed securities. Piper Jaffray was then fined $1.25 million by Finra’s predecessor.
“Suggesting a bond fund instead of a cd is not necessarily a bad thing, as long as you explain the risks,” says Russel Kinnel, director of mutual fund research at Morningstar. “It’s not that you have to tell everything, but you should give people a realistic expectation.”
A fund’s marketing materials, including its ads, Web site, brochures and mailings, are supposed to fairly balance risks and potential rewards as described in the prospectus. But prospectuses often run to dozens, or hundreds, of pages, meaning they go unread. That leaves plenty of opportunity for the more accessible statements–in brochures or brokers’ spoken pitches–to tout the positives and play down, or leave out, the negatives.
Often the problem is not that cautionary information is undisclosed but that investors are too overwhelmed to grasp it. At least some of the blame goes to the Securities & Exchange Commission, which oversees the fund business. SEC lawyers, it seems, are so obsessed with the long-winded and confusing prospectuses that they don’t have time to revamp the ads and the brochures.
The SEC did amend its advertising regulations five years ago amid concerns that fund sponsors had created “unrealistic investor expectations” during the tech bubble by playing up eye-popping performance data. The new regs require ads to include a toll-free number to obtain performance data through the most recent month and the bromide that “past performance does not guarantee future results.”
Another reform would go further. It would require fund vendors to boil down fund essentials–including risks–to an easily digestible summary that appears on its own or at the front of a prospectus. The SEC staff proposed this rule last November, but the industry has so far fought it off. Instead of a CliffsNotes-style summary, investors are being treated to enriched detail about two hazards that have almost vanished: rapid-fire market timing and after-hours trading. This represents the SEC’s response to fund industry scandals of a few years ago.
“It is unreasonable to expect an investor to read all of the pages of a prospectus and fully understand and interpret the disclosures. That’s why investors look to marketing material,” says Steven Toskes, a securities lawyer in Boca Raton, Fla.
Finra, which is supposed to enforce the SEC’s promotional regulations, reviews marketing materials with the aim of ensuring that claims fairly reflect the risks laid out in the prospectus. But it doesn’t determine the validity of the prospectus, which can also be an issue.
Investors have charged Wachovia (nyse: WB – news – people )’s Evergreen Investments of securities fraud in a Massachusetts federal court for allegedly failing to fairly represent risks in the prospectus for its Ultra Short Opportunities fund. The complaint acknowledges that the prospectus lays out risks arising from interest rate moves, derivatives and mortgage-backed securities. But it claims the prospectus fails to explain that those risks “entirely undermined the fund’s stated investment objective” of preserving capital and minimizing fluctuations in value. (Wachovia doesn’t comment on pending litigation.)
Charles Schwab (nasdaq: SCHW – news – people ) asked visitors to its Web site in 2006 if they were “Looking for a way to earn better yields on your long-term cash without taking on significantly higher risk?” Its answer was YieldPlus, an ultrashort-term bond fund, which that year became the eighteenth-fastest-selling mutual fund and at its peak had $13.5 billion in assets.
Only those investors who waded to page 3 of the 30-page YieldPlus prospectus discovered warnings that problems in the mortgage market could cause the fund to lose money. That September Schwab amended the fund’s so-called Statement of Additional Information, essentially the even less read second part of the prospectus, to state that the fund could invest more than a quarter of its assets in mortgage-backed securities.
With nearly half its assets in such securities, the fund fell 18% in March and is down 35% in the past year. Investors have filed Finra complaints, alleging misrepresentation and omissions, as well as class actions. You can’t “Talk to Chuck” about this one, however. A Schwab spokesman says neither the man, nor the firm, cares to comment.