Judge Rules Against Schwab in YieldPlus Fund Case

Last week a judge ruled that Charles Schwab (NYSE: SCHW) violated the law with its YieldPlus Mutual Fund (SWYSX) when it held upwards of 50% mortgage-backed securities without shareholder approval. (See "Angry Schwab bond-fund customers win in court" and "Judge Rules Charles Schwab Violated Law in YieldPlus Mutual-Fund Case.") This case, somewhat surprisingly, has not been publicized much.  With the fund seeking to increase its appeal to the masses, its managers loaded up on risky mortgage-related structured debt to increase its yield, and consequently its assets ballooned to $13 billion in 2007.  In other words, the strategy worked.  The collapse of the mortgage market in 2008, however, led the fund to lose a whopping 36% of its value, a far cry from the advertised description of the fund as a low-risk alternative to money market and cash accounts.  The fund is currently described as seeking "high current income with minimal changes in share price."  This lawsuit reminds me of the one filed against Schwab's total bond fund for the same reason, which I reported in my Lazy Portfolios post.

In 2001, Schwab apparently stated that the fund would hold a maximum of 25% of its assets in any one particular industry, but amended it in 2006 stating that its fund managers reserved the right to make investment decisions at its own discretion without shareholder approval.  The judge ruled that this went against the Investment Company Act of 1940 that states that once a mutual fund proposes a policy (as Schwab did in 2001), it can only modify the asset allocations after an okay from the majority of the shareholders.  While Schwab publicly disclosed its holdings at all times and was transparent in its investments (this certainly wasn't a hedge fund-like case wherein the fund was not clear with its investments), it neglected to seek approval from its investors when changing investment philosophy in an attempt to increase the funds yield and attract additional monies.

Lead attorney for the plaintiff, Steve Berman, explained:
Plaintiffs contend that Schwab wanted complete, unfettered control of the fund so the managers could drive up yields, to in turn attract more investors as YieldPlus grew into the largest ultra-short fund in the country.  Schwab's money managers did, indeed, jump in and gamble, but with other people's money.

This case does not signal to me that Schwab has a wider corporate issue and that you should no longer trust them with your money.  Personally, I think Schwab has some really great low-cost offerings and is a customer-friendly discount brokerage with ample resources and insightful research reports.  In this isolated incident, though, specific fund managers made a particularly egregious judgment in an effort to get more investors into the fund.  This could have easily happened at a variety of different mutual fund families and I still trust Schwab as much as I would any other highly-respected brokerage firm.

There are two important lessons to learn from this debacle, though.  First, monitor your investments regularly and look closely at the holdings of every fund you own to ensure that it meets your standards and risk tolerance.  In this case, simply reading the prospectus or using a fund analyzer tool online for the YieldPlus fund would indicate to any investor that it held greater than 50% of its holdings in privatized mortgage-backed securities.  That would be a red flag to any educated investor as this clearly is at odds with the funds intended risk/reward profile.  Schwab did not try to cover this up and the managers disclosed the funds holdings at regular intervals as required by the SEC.  On the other hand, their general description of the fund was misleading and thus, as an investor, you should learn to delve deeper by reading the prospectus and holdings in detail.  This applies to all sorts of funds, especially "closet-index funds" - that is, actively managed funds that charge you a hefty expense ratio, but when you breakdown the holdings, it is essentially tied to an index benchmark and could be held in a more cost effective manner.  The second lesson from this case is that you must resist the urge to chase yield.  Money managers knew that loading up on MBSs would help sell the fund as the yield surged, but this certainly backfired.  Legendary Vanguard founder Jack Bogle explained that this was a classic example of a firm "reaching for yield" to attract new investors, and a typical action many mutual fund companies cannot resist.  "The message over and over again," Bogle says, "is, 'Go the straight and narrow.'"

The amount of damages will be determined in a trial beginning May 10.

Update 4/20/10: Schwab has decided to settle for $200 million rather than go to trial.   Schwab's statement indicated that settling "allows the company to avoid the distraction and uncertainty of a trial, and the further possibility of a protracted appeals process."  They admit no liability under the settlement, which is still awaiting final court approval.

Book Review: The New Coffeehouse Investor

Bill Schultheis' The New Coffeehouse Investor (Portfolio, rev ed. 2009, 224 pp) builds upon his 11-year old original to devise a simple and common sense approach to long-term saving and investing.  This certainly is not a dense book of tactical investing strategies and terms, so if you're looking for that, this is not where to find it.  Rather, Schultheis essentially writes a "life book" that happens to be primarily focused on investing by saving well, approximating the stock market average, lowering costs, and diversifying with an appropriate asset allocation plan.  The author intersperses his own personal stories throughout, which I found made the book more enjoyable and an easy read.  Not only does he have wisdom in the investment realm, but Schultheis really attempts to give larger "living life advice" and parallels his life experiences with that of investing.  

First, Schultheis begins the book speaking about his interactions with other "coffehouse investors" - that is, friends whom he'd discuss investing ideas at a coffehouse in Seattle with.  Building on his 13-year Wall Street career mostly with Smith Barney, Schultheis argues that listening to stock brokers is a fool's gold and arguments for individual securities such as "I own world-class companies" doesn't hold water, especially if your age and risk tolerance suggests a certain allocation to bonds is more appropriate.  The author really talks about living life (and retirement) to the fullest, rather than constantly worrying about stock picks and your broker.  There are several side stories about his mountain climbing experiences as well as stories from his youth such as building an airplane with his brother.  They serve a couple purposes - first, to make the book interesting and relay these lessons to investing by using various analogies and metaphors, and also to stress what's really important in life - and that's living it.

Schultheis espouses three main principles that guide his philosophy: 1.) Don't put all your eggs in one basket; 2.) There is no such thing a free lunch; and 3.) Save for a rainy day.  In particular, he takes a fairly significant chunk of the book talking about the importance of saving early and the power of compounding; certainly not to the level of not being able to enjoy life, but making certain sacrifices in order to have the retirement you want.  He outlines in details the effects of high expense ratios in mutual funds can have on your bottom line as well as inflation risk, holding small company funds, and the significance of re-balancing.  While Wall Street likes you to believe that stock market risk is huge when compared to inflation risk in the long-term, when looking at 10-year returns on the market, you'll notice that rarely does it go down for a significant period.  Of course there are no guarantees, but for long-term investing, taking a chance on stocks is the way to go and really the ultimate risk is inflationary in nature.  Schultheis urges individuals to ignore the short-term Wall Street stuff and to focus on the big picture.  We know the stock market is volatile in the short-term, but if your investment horizon is significantly longer, this should not be terribly concerning to you.

The author goes on to explain while certain funds will outperform in the index at large for certain periods/categories, sustaining such an outperformance is unheard of and underperfoming by even a seemingly small amount over the course of a long period can lead to a huge reduction in assets.  So, while a fund may be the #1 performing large-cap for the last three-month period, this really is meaningless in the long-run and chasing such returns ends up biting you in the butt.  It's better to have a plan to match the market return with the lowest fees possible, Schultheis argues.  Even large state pension funds follow this strategy, with California indexing 85% and New York 75% (although the author doesn't mention that university endowments typically employ hedge-fund like strategies unlike state funds counterparts).

Schultheis proposing a hypothetical situation and game that he calls "Outfox the Box" that illustrates the index fund versus actively managed fund (or individually picking securities) quite well, so I thought I'd mention it here.  There are ten boxes with money in them, ranging from $1,000 to $10,000 in $1,000 increments:

You are told to choose one.  When the boxes show the amounts, it's obvious you'll choose the $10,000 one.  But let's say it looks like this:

$8,000 ? ? ? ?
? ? ? ? ?

In that case, you should choose the $8,000 since it's not worth the risk as chances are you'll get much less than $8,000 if you choose a "question" box.  Picking a "question" box is essentially gambling, and investing should be going with the percentages.  Most likely, you'll choose a box with less than $8,000, and this is equivalent to choosing an actively managed fund as they typically lag the market on top of having higher fees.  A fund that has outperformed in the past is unlikely to do so in the future, and over a 10-year span, something like 85% of actively managed funds lag their benchmark.  Schultheis explains that Wall Street is essentially trying to convince you to give them your money so that their experts can "outfox the box" even though the odds are quite grim that they can do so.  On top of that, they charge much more so the chances of your total return improving is even slimmer.

In the end, this book provides some great analogies and sound advice for simple, long-term investing.  It is not a detail oriented analysis on various strategies and securities, but rather a "life book" that uses life lessons and the author's personal experiences in order to give you a clear picture of how to apply such fundamentals to your own life to ensure financial well-being.   The book is an easy read and provides many examples and supporting figures for his philosophy, and, as such, I think it's a great read for somebody formulating an investing plan.  It isn't, however, revolutionary in nature with its research findings (not that it needs to be) and some may find the tangents distracting rather than enriching.  I found it an enjoyable read that looked at a few topics from a new angle, while reinforcing the guiding principles of my own investing philosophy.

Rating: 4 out of 5 stars
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