Morningstar Advisor - Spring 2008 - 76

Bond Fix Anatomy of a Mutual Fund Disaster By Lawrence Jones How redemptions and illiquid market conditions conspired to unravel two funds. Unlike their closed-end and hedge-fund counterparts, open-end mutual fund managers must deal with daily asset flows into and out of their funds. Cash flows can be tricky for managers to handle. Managers often see significant redemptions in periods when their funds have fared poorly, forcing them to sell into markets where the fund’s securities have been declining in value. Inflows, on the other hand, often occur after years of strong performance, presumably when market valuations in the areas management traffics are less attractive. Although difficult, many managers are adept at navigating their funds through these disruptions. Occasionally, however, dramatic swings in cash flows can have disastrous consequences for managers and fund shareholders. We will look at two recent cases that exemplify the extreme of what can happen on the redemption side of the equation—when masses of shareholders flee a fund during a tough market. We will also point out some warning signs that will help advisors avoid funds that are in poor positions to withstand a torrent of outflows. Like Water portfolio. Unlike large-cap equity funds, which buy securities in one of the most liquid markets in the world, fixed-income funds sometimes trade in securities that may be very difficult to get out of quickly. The 2007-08 subprime mortgage meltdown and liquidity crisis is only the most recent example of bond market illiquidity (albeit an extreme case). In a classic flight to quality, investors became wary of making risky credit-quality bets and fled sectors such as high yield, bank loans, asset-backed securities (particularly subprime-exposed bonds), and troubled financial-sector corporate debt. Liquidity for bonds in these markets evaporated as risk-averse investors shifted assets away from regions of the market perceived troubled toward areas thought safe (which drove strong returns in U.S. Treasuries and TIPS). For mutual funds that remained in riskier areas, however, few things could be more dangerous than being forced to sell into a declining and illiquid market to meet shareholder redemptions. But that’s exactly what happened to SSgA Yield Plus SSYPX and Regions Morgan Keegan Select High-Income MKHIX. Redemptions and Illiquidity Don’t Mix subprime-exposed holdings were originally rated AA and AAA.) Over the trailing year, through March 7, the fund saw a 22% loss, a terrible result for an offering that is supposed to be close to a money market fund in terms of safety. During the past year, the fund’s losses spurred redemptions, which in turn spurred greater losses, and so on. Combined, outflows and capital losses drove the fund’s assets down to $28 million by Feb. 29, from $207 million on June 30, a loss of more than 85% in roughly half a year. In the third quarter of 2007 alone, the fund saw $106 million in outflows, as managers were forced to sell shaky mortgage-related securities at a time when few wanted them. The managers likely were forced to take deep discounts on their holdings to meet redemptions. State Street recently replaced managers Frank Gianatasio and Robert Pickett with Brett Wander and Brian Kinney. It’s not clear, however, that the change will stem the flow of what little assets remain or solve the fund’s trouble. Meanwhile, the situation wasn’t any better over at the high-yield bond fund Regions Morgan Keegan Select HighIncome (and at other bond funds run by the same advisor). Liquidity, as Warren Buffett once suggested, is taken for granted until it’s no longer there. It also matters greatly when determining the impact that redemptions can have on a Markdowns in its asset- and mortgage-backed securities demolished the record of SSgA Yield Plus, an ultrashort-bond fund. (Many of its 76 Morningstar Advisor Spring 2008

Morningstar Advisor - Spring 2008

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