The Risk of No Return

Tuesday, 01 February 2011 Posted in SpringReef Insights

Let’s talk about risk.

Last month, the Securities and Exchange Commission charged Charles Schwab Corp. with misleading investors about the safety of YieldPlus, an ultra-short bond fund that regulators claim was marketed as a cash-equivalent investment and a safe substitute for money market funds.

“Safe substitute” seems to have been something of an overstatement. As it currently stands, the share price of YieldPlus has fallen 50% and investors have been left with about $1 billion in losses, much of which will not be recovered.

So, what happened?

According to regulators, Schwab violated the concentration limits stated in its prospectus, investing so heavily in mortgage-backed securities that at one point they ballooned to more than 90% of the fund’s assets.

Adding to the concentration problem, the company came up with a creative definition of maturity, conveniently stowing it away in the footnotes of the YieldPlus prospectus. Typically understood as the date a bond’s principle comes due, Schwab redefined maturity as the date a bond’s interest rate was reset. According to this definition, a security scheduled to mature in 25 years, but whose interest rate reset on a monthly basis, actually had a one-month maturity. As a result of this sleight of hand, less than 6% of assets in the fund had a true maturity of less than six months, with some securities maturing as far away as 2049 – interesting for an investment marketed as an “ultra-short bond fund.”

Schwab – which earned $17.5 million in fees on the fund – will end up coughing up a few hundred million dollars in settlements and has suffered a significant blow to their credibility and reputation.

However, the issue here isn’t just about Schwab and YieldPlus. The ill-fated fund is only the latest example of fixed income investments that have over-promised and under-delivered. Think back to auction rate securities, “principal-protected” structured notes, limited partnerships and government plus funds. In all of these cases, investors were lured with promises of higher yields, only to lose both yield and significant amounts of their principal.

As we reflect on YieldPlus and its unfortunate predecessors, we suggest readers keep one simple notion in mind – every single investment entails risk, and with market forces being what they are, that risk is generally reflected in price, yield or potential return. Therefore, if someone suggests an investment is going to return more than a money market fund, it’s wise to assume it also entails more risk than a money market fund.

Great advisors put the concept of risk versus return front-and-center in client conversations. They are knowledgeable about the solutions they offer and are careful to provide clients with a full overview of each – the advantages, the drawbacks and the levels of risk associated with anticipated returns. They are also more experienced, more ethical and less susceptible to common investment mistakes – mistakes which often include an overzealous emphasis on return without an appropriate focus on risk.

As a personal example, I’ve recently been contacted by a number of financial advisors offering their points of view on the current municipal bond market. As most of you know, municipal values have declined significantly since September given concerns around the financial health of state and local governments. This decline has sparked a very intense public debate amongst analysts and investors about the prognosis for municipals going forward.

Each advisor offered me thoughtful recommendations supported by views of highly-regarded analysts, and while some recommendations happened to be contrary to one other, each was thorough and offered a comprehensive discussion of risk. In all cases, the conversation was about the possibility for return given a particular foundation of risk.

This is exactly what great advisors do. They offer clients a 360-degree view of their proposals, communicating in detail both the opportunity and the commensurate risk.

Unfortunately, in the financial services industry the discussion of risk versus reward is frequently skewed towards the latter. All too often advisors are unaware of, don’t understand or choose not to communicate risk.

For those of you working with advisors leaning a bit too heavily on the benefit side of the equation, below are listed ten types of risk of which you should be aware. They’ll provide you with a good starting point for a risk discussion between you and your advisor.

Important Types of Risk:

  • Principal
  • Liquidity
  • Interest Rate
  • Market
  • Inflation
  • Business
  • Credit
  • Regulation
  • Valuation
  • Exchange Rate

In truth, any investment can go wrong, even those recommended by exceptional, talented and trusted advisors. However, investments based on a thorough review of potential return and commensurate risk are less likely to inflict the type of surprising, intolerable portfolio damage we’ve seen with YieldPlus.

As is always the case for our clients and subscribers, should you have any questions about risk or general investment-related issues, please don’t hesitate to contact us. We're always happy to help.

Please feel free to contact us if you have any questions about our Insights pieces.

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