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.


  1. This slipped under the radar for me. The scary part is that advisors use ultra short funds as funding vehicles for retirees who are on distribution, i.e. drawing down their "nest eggs". Many advisors suggest putting at least a year's worth of payments in these funds to avoid having to sell stock in a depressed market. It is presented as a way to get a bit extra yield for ultra safe funds. Thankfully the investors won. You never can tell when these things go in front of a judge.

  2. Thanks for the comment as well as linking me on your blog. I agree, it's definitely a scary situation. I'm sure Schwab advisors told retirees that the YieldPlus fund was a "safe" investment (always a misnomer in my book as the only truly safe place to put your money is in an FDIC insured bank account) that provided a bit more yield without increased risk. I'd think that many of them didn't even keep close enough tabs on it themselves to realize that it loaded up on MBSs, and instead relied solely on the description. And clearly, Schwab's advisors would encourage clients to invest in their own company's funds. This is yet another reason to avoid actively managed funds as the philosophy of the managers can change without warning, whereas you always know what you're getting with index funds. Having said that, Schwab's Total Bond Market (SWLBX), which is supposed to track the Barclays Capital U.S. Aggregate Bond index, was down 4.42% in 2008 (total return) while the benchmark was up 5.24% in the same period. Obviously, we'd expect some tracking error, but nearly 10% is ridiculous. A similar fund, VBMFX, was up 5.05% over the same period, while AGG had a total return of +5.90%. (Although SWLBX's expense ratio and relatively small total assets certainly didn't help.)

  3. Morningstar still gives SWLBX 2 stars - should it be negative stars? I use Schwab because I feel comfortable with their site but I am leery of all advisors theirs included. It is just too easy with minimal experience to pass the Series 7 and Series 65 and become an advisor. Too often advisors are chosen on their personality traits - especially their persistence and not on their smarts.
    If I'm going into combat I want to go in with someone who has been through it.
    The SWLBX story should be on every brokerage statement in double sized font and bolded. It happens too frequently.

  4. I had written a long response and somehow it got deleted, so here's my attempt at it again. In any event, I am also a Schwab fan as their site is great, they have ample research reports, and offer several low cost index funds and ETFs, particularly for those starting out without a lot of assets who cannot reach the $3,000 minimum per fund required by Vanguard. On top of that, they have low commission fees and have made a valiant effort to become a one-stop shop for all your financial needs by offering competitive banking solutions that link to your brokerage. Having said that, I agree with you that it is prudent to be cautious with any advisor, particularly those that are on commission and are essentially salespeople. Often, advisors don't have their clients' best interest at heart and instead their #1 priority is to make money for themselves. In the case of SWYSX and SWLBX, their managers clearly deviated from the outlined prospectus. That is not incredibly shocking for SWYSX as it's an actively managed fund, but an index fund is supposed to simply track an index. Thus, the underperformance is certainly a concern. Personally, any index fund that has a 1, 2, or 5 star rating by Morningstar is a red flag to me (or, at the very least, a yellow flag). If it's truly tacking the index, it should be about average (3 stars), but it's reasonable for them to get four star ratings since the fees are presumably much lower than similar funds. To be fair, looking at the holdings now and the performance in the last year, SWLBX has seemed to right the ship a bit, but I still wouldn't invest in it because the 0.55% expense ratio is far too high for a bond index fund (and the managers in the past clearly deviated from the plan so their track record isn't the greatest). If you invested $10,000 on 5/1/2009, it would have grown to $10,780 in SWLBX while Barclays US Aggregate Bond Index grew to $10,843.34. The difference is largely explained by the expense ratio. As a comparison, VBMFX grew to $10,819.41 and AGG grew to $10,809.40. This post certainly wasn't meant to suggest to avoid Schwab - I personally think Schwab offers one of the best brokerage services. Rather, it serves as a cautionary tale to keep tabs on your investments and examine the holdings of all your funds periodically to ensure that it matches your tolerance for risk for that particular portion of your portfolio.

  5. Its amazing what these stock brokers can get away with.

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