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.