Oppenheimer Champion Income Fund
By: Geng Deng and Craig McCann (May 2010)
During the second half of 2008, Oppenheimer's Champion Income Fund lost 80% of its value - more than any other mutual fund in Morningstar's high-yield bond fund category. These extraordinary losses were due to the Fund's investments in credit default swaps (CDS) and total return swaps (TRS). The Fund used CDS and TRS to leverage up the Fund's exposure to corporate debt and asset-backed securities, including Mortgage-Backed Securities and swap contracts linked to Residential and Commercial Mortgage-Backed Securities indices.
What Does a Mutual Fund's Term Tell Investors?
By: Geng Deng, Craig McCann, and Edward O'Neal (Apr 2010)
Published in the Journal of Investing, Summer 2011, Vol. 20, No 2: pp. 50-57.
In a previous article, we highlighted a flaw in the average credit quality statistic frequently reported by bond mutual funds. That statistic understates the credit risk in bond portfolios if the portfolios contain bonds of disperse credit ratings. In this article we address a similar problem with bond mutual funds' reporting of the average term of their portfolios. The somewhat ambiguous nature of this statistic provides an opportunity for portfolio managers to significantly increase the funds' risks, credit risk in particular, by holding very long-term bonds while claiming to expose investors to only the risks of very short-term bonds.
Morningstar uses a fund-provided statistic - the average effective duration - to classify funds as ultra short, short, intermediate or long-term. Funds have figured out how to hold long-term bond portfolios yet be classified as ultra short-term and short-term bond funds. We show that extraordinary losses suffered by these funds in 2008 can be explained by the how much the bond funds' unadulterated weighted average maturity exceeded the maturities typically expected in short-term bond funds.
What Does a Mutual Fund's Average Credit Quality Tell Investors?
By: Geng Deng, Craig McCann, and Edward O'Neal (Nov 2009)
Published in the Journal of Investing, Winter 2010, Vol. 19, No. 4: pp. 58-65.
The SLCG study explains that the Average Credit Quality statistic as typically calculated by the mutual fund companies and by Morningstar significantly overstates bond mutual funds' true credit quality. This statistic is based on Standard & Poor's and Moody's assessment of the credit risk of the individual bonds in the portfolio and is reported to mutual fund investors using the familiar letter scale for rating the credit risk of bonds.
The study concludes that, for instance, funds that have the credit risk of a portfolio of BBB-rated bonds often report an Average Credit Quality of A or even AA and that given how this statistic is calculated, portfolio managers can easily manipulate their holdings to significantly increase their credit risk and thereby their yield without increasing their reported credit risk at all. Since bond fund managers compete for investors based on yield and risk, the authors find that fund managers who report Average Credit Quality have the ability and the incentive to increase but underreport the credit risk in their bond mutual fund portfolios.
Structured Products in the Aftermath of Lehman Brothers
By: Geng Deng, Guohua Li, and Craig McCann (Nov 2009)
SLCG's prior research showed that structured products were poor investments because they were significantly overpriced when offered and were, at best, thinly traded thereafter. SLCG concluded that overpriced structured products survived in the marketplace because structured products' opaqueness obscured their true risks and costs and the high fees earned by underwriters and salespersons.
The current SLCG study presents a brief history of the structured products program at Lehman Brothers and illustrates many of its points with Lehman structured products examples including Principal Protected Notes, Enhanced Return Notes, Absolute Barrier Notes, Steepeners and Reverse Convertibles. The study reports that the spectacular failure of Lehman brothers in September 2008 left investors holding more than $8 billion face value $US-denominated structured products. Dr. Craig McCann, the study's principal author, explained that the Lehman experience is especially instructive of the opportunity for mischief presented by financial engineering; faced with increasing borrowing costs Lehman stepped up its issuance of structured products where its credit risk would not be priced into the debt.
Charles Schwab YieldPlus Risk
By: Geng Deng, Edward O'Neal, and Craig McCann (Jul 2009)
From June 2007 through June 2008, investors in YieldPlus (SWYSX and SWYPX) lost 31.7% when other ultra short bond funds had little or no losses. Schwab had marketed YieldPlus as a low risk, higher yielding alternative to money market funds.
The report concludes that YieldPlus's extraordinary losses occurred because the fund held much larger amounts of securities backed by private-label mortgages than other ultra short bond funds. In doing so, Schwab's fund violated concentration and illiquidity limits stated in its prospectus. These private-label mortgage-backed securities holdings had given YieldPlus a slight advantage over its peers prior to 2007. Unfortunately, the extra yield was an order of magnitude smaller than the losses that followed when the value of structured finance securities - especially those backed by mortgages - dropped significantly.
SLCG also found that Schwab significantly inflated the value of YieldPlus's holdings and therefore its NAV in late 2007 and early 2008. By inflating the YieldPlus fund's NAV, Schwab provided existing investors incorrect information about the value of their investments and caused new investors to overpay for shares in YieldPlus.
Regions Morgan Keegan: The Abuse of Structured Finance
By: Craig McCann (Jan 2009)
Investors in six Regions Morgan Keegan (RMK) bond funds lost $2 billion in 2007. The RMK funds held concentrated holdings of low-priority tranches in structured finance deals backed by risky debt. We provide five examples of the asset-backed securities RMK invested in: IndyMac 2005-C, Kodiak CDO 2006-I, Webster CDO I, Preferred Term Securities XXIII, and Eirles Two Ltd 263.
RMK did not disclose the risks it was taking until after the losses had occurred. In fact, RMK misrepresented hundreds of millions of dollars of highly leveraged asset-backed securities as corporate bonds and preferred stocks thereby making the funds seem more diversified and less risky than they were. RMK and Morgan Keegan also materially misled investors by comparing these funds to indexes which only contained corporate bonds despite the fact the RMK fund held three times as much asset backed securities as they held corporate bonds.
The RMK funds held roughly 2/3rds of their portfolios as of March 31, 2007 in structured finance securities and only 22% or 23% in corporate bonds. RMK's structured finance holdings were roughly 90% in mezzanine and subordinated tranches and only 10% in senior tranches. The vast majority of tranches by market value are classified as 'senior' and so the RMK funds were overwhelming invested in the bottom of structured finance deals'capital structures. The attached Excel file contains SLCG's classification of securities in the RMK by senior versus mezzanine/subordinated.
Download SLCG's Classification
Roughly 90% of the losses suffered by the RMK funds identifiable from their public filings during the last three quarters of 2007 when the funds collapsed were from the funds' holdings of structured finance securities. The attached slides summarize SLCG's classification of losses in the RMK funds in the last three quarters of 2007.
Download the RMK Losses Due to Structured Finance and Internally Priced Securities slide
Download the RMK Losses Due to Structured Finance and Internally Priced Securities backup
An Economic Analysis of Equity-Indexed Annuities
By: Craig McCann (Sep 2008)
At the request of the North American Securities Administrators Association, Dr. McCann authored a White Paper on equity-indexed annuities in support of the SEC's proposal to provide federal investor protections to purchasers of equity-indexed annuities.
Dr. McCann concluded that:
- Existing equity-indexed annuities are too complex for investors to understand.
- This complexity is designed to allow the true costs to be hidden
- The high hidden costs in equity-indexed annuities are sufficient to pay extraordinary commissions to a sales force that is not disciplined by sales practice abuse deterrents found in the market for regulated securities.
- Unsophisticated investors will continue to be victimized by issuers of equity indexed annuities until truthful disclosure and the absence of sales practice abuses is assured.
A CMO Primer: The Law of Conservation of Structured Securities Risk
By: Craig McCann (Jun 2007)
The collapse of Brookstreet Securities and bailout of two Bear Stearns hedge funds have focused attention on collateralized mortgage obligations (CMOs). These recent CMO losses closely parallel CMO losses in 1994 when a significant increase in interest rates caused many bond mutual funds to fall in value far more than expected. Today's CMO losses resulted from the relatively recent introduction of CMOs with substantial credit risk and the inadequate or misleading way in which that credit risk was disclosed. Dr. McCann provides a selective history and a brief description of CMOs.
Closed-end Fund IPOs
By: Edward O'Neal (Jun 2007)
Dr. O'Neal describes a pattern of consistent losses relative to NAV observed after the IPO of closed end funds. Closed-end funds IPO at a 5% premium to their NAVs and within 6 months trade at a 5% discount to their NAVs. It appears that investing in a closed-end fund at the IPO is dominated by investments in seasoned mutual funds. This suggests that closed-end fund IPOs don't pass the NASD's 'reasonable basis' suitability test and recommendations to buy a closed-end fund at the IPO should therefore be per se unsuitable.
Corporate and Municipal Bonds
By: Michael Piwowar (Jun 2007)
Corporate and municipal bonds are substantially more expensive for retail investors to trade than similar-sized trades in common stocks. Trading costs including explicit commissions, mark-ups and mark-downs are significantly higher for retail-sized (small) bond trades than for institutional-sized (large) bond trades. Dr. Piwowar summarizes key findings in the academic finance literature on bond market trading costs, including research on the effects of adding price transparency to the bond markets, and explains how bond trading costs can be hidden in realistic examples using simple numerical examples.
