SEC proposes new disclosures for target-date funds

On Wednesday June 16, 2010, Federal regulators proposed new disclosure rules for target-date retirement funds that would require sponsors to spell out how they are investing the money and to warn about risks.
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Under the SEC proposal, target-date funds' marketing materials would have to include a prominent table, chart or graph showing the allocations among the various assets over the life of the fund. A statement would have to explain that the asset allocation changes over time, and tell prospective investors that they should consider their financial situation and tolerance for risk before going into a fund.

Target-date funds came under criticism during the market meltdown of 2008 and in its aftermath. Among 31 funds with a 2010 target date, the average loss in 2008 was nearly 25 percent.

Before the vote on the proposed rules, SEC Chairman Mary Schapiro stated: "It's clear that investors need more information than just the date in a fund's name."

Target Date Funds Can Be "Way Off Target"

Tom Brakke, CFA, offers new criticism today on Morningstar of Target-Date Mutual Funds, despite this investment vehicle's reputation as one of the hottest investment products of the last decade.

According to Brakke, many target date funds were structured based upon questionable assumptions about asset classes and how they perform over time. "Historical returns, the variability of those returns, and the correlations among the returns of different types of assets were used in asset allocation models as if they were facts of nature." Brakke says many target date funds with a reference date of 2010 have received much attention, "since many who held the funds on the verge of retirement saw large losses in their account balances during 2008 (with some drops exceeding 30%)." Click here for the entire article. (Subscription may be required).

In Brakke's opinion the main flaw is that deciding that someone should have X% in equities and other risky assets without regard to the valuation of those assets ignores an important relationship: The probability that stocks will perform worse than their historical average return increases as valuations rise.

Merrill's "Penalty Box"

Barry Ritholtz of the Big Picture has the interesting story of two brokers who run managed accounts at a large firm that "[r]hymes with Schmerrill." It should be a warning to all investors--brokerages compensate their brokers for investing your money, not for saving your money by pulling it out of failing investments. In fact, brokers who saved their clients' money by putting them in cash are being punished.

These two gents run a few $100 million dollars in managed accounts. They are mostly stock jockeys, but they have a smattering of bonds as well. Their assets are spread out amongst stocks they selected, in house managers, and other mangers on their firm’s platform. Typically, the clients are charged 1.0-1.25% on their assets. Various products (I hate that word) will pay the broker more or less depending upon the fund manager’s arrangements with the house.

As is typical of brokers with this size asset base and seniority, their payout was about ~43%.

Let’s do some quick math before we get to the heart of the conflict: On $300 million in assets, let’s call it $3.3 million dollars in gross revenue to the firm. That’s about $1.4 million to them, from which they pay a few sales assistants, T&E, etc. Thus, they each should be making about half million dollars annually before Uncle Sam takes his.

Here’s where things get interesting: Early in 2008, they moved aggressively into cash. (Obviously they are TBP readers). For most of the year, they run about 20% bonds, plus 5% percent stocks (some client would not sell). All told, about 75% of their asset base is in money market funds, which pays out essentially nothing to the broker — but preserves the clients investments. Late in the year, they put a toe back in the water.

Overall, the clients do very well. In a year where the markets are practically cut in half, their clients lose about 10%. The investors are ecstatic, and while the two brokers annual compensation was schmeissed — they went from over $3 million gross to under $1 million — they have happy, referral making clients to rebuild their business upon. Its a short term income hit that should generate gains over the long term. And, they got there by doing the right thing.

Now, that drop in income alone raises conflict issues. I tell clients who ask why they are paying 1% to sit in Cash that they are not — they are paying 1% to not be losing 45% in equities, and to have us tell them when to go back into stocks. We think that’s worth 1%, and if you disagree, well talk to your friends who have seen their investments destroyed.

Here’s where things get completely misaligned. When 2009 rolls around, their manager calls them into his office, and says: “Bad news, boys. Your revenues dropped so much last year you are in the Penalty Box. As per your contract, your payout for this year is 30%.”

Sparer Law Group Files Class Action Against Oppenheimer Bond Fund

The Sparer Law Group has filed the first class action lawsuit on behalf of investors who purchased the Oppenheimer California Municipal Fund (Symbols: OPCAX, OCABX, OCACX) between September 27, 2006 and November 28, 2008. The case was filed on February 4, 2009 in the United States District Court for the Northern District of California, case number C 09-00567 SI. See our press release here.


The lawsuit alleges that the Fund's Registration Statements and Prospectuses misled investors about the Fund's investment objectives and underlying risk by describing the Fund as seeking current income "consistent with preservation of capital." The Fund lost over 41% of its net asset value ("NAV") in 2008. By comparison, the average loss for funds within the same Lipper peer group over this period was only 11.5%.

"The promise that a municipal bond fund follows a strategy designed to preserve capital cannot be just a sales pitch. It has to be reflected in an objective investment approach," said Alan W. Sparer, lead counsel. "Investors put their 'safe' money and retirement savings in muni bonds. These funds are not the place for speculative strategies or junk bond investments."

The lawsuit alleges that the Oppenheimer California Municipal Fund policies and operations ignored the preservation of capital objective by concentrating 78% of its assets in bonds rated at the lowest investment grade or below, and concentrating 60% in bonds that were not rated by any independent rating agency. In addition, 33% of the Fund's investments were placed in Dirt Bonds, which are based on contracts for land developments that have not been built yet and were especially vulnerable to the recent declines in California's real estate market.

In addition, the lawsuit alleges that Oppenheimer failed to disclose that, because of the Fund's overconcentration in lower rated bonds and bonds that had not been rated by any independent agency, there was a significant risk that more than 25% of its assets were in junk bonds, a violation of the Fund's fundamental investment policy.

The NAV of the Oppenheimer California Municipal Fund decreased by more than $1.1 billion in 2008.

A copy of the complaint is available here.

Investors who lost money in the Oppenheimer bond funds should contact the Sparer Law Group to investigate potential avenues for recovery.

Morningstar Flunks Oppenheimer Bond Fund

Morningstar gives Oppenheimer an 'F' for failing to disclose the additional risks it had taken on in its bond funds:

""The managers bought complex, off-balance-sheet swap contracts that created a leveraging effect on the funds," Gogerty said. The managers made no attempt to tell investors that the funds were taking on additional risk, he said."

The article states that "Oppenheimer failed investors by not telling them that two of its bond funds had recently taken on extra risk." The end result was that "Oppenheimer's normally stable Champion Income and Core Bond funds saw huge losses in 2008, dropping 78% and 36% respectively."

Oregon Investigating Oppenheimer Bond Funds

Officials demand financial data from OppenheimerFunds:

Oregon State officials are investigating Oppenheimer, which managed Oregon's College Savings Network:

"The bond funds in question contributed to exorbitant losses in the network's conservative portfolios. OppenheimerFunds' Core Bond fund declined about 35 percent last year. The short-term government fund lost 6 percent last year. By comparison, a benchmark measure of its peers -- Barclays Capital U.S. 1-3 Year Government Bond Index -- gained 6.7 percent."

What Feeder Fund Managers Suspected About Madoff

It turns out that many of Madoff's feeder fund managers--the people who brought much of the money from individual investors into Madoff's Ponzi scheme--had long suspected that Madoff was engaging in illegal activity. According to Bloomberg, they just assumed that they were benefiting from the illegal activity and not being victimized by it. They thought that Madoff was using his position to "front-run" trades by his clients.

The purported mission of such feeder funds was to vet hedge funds for wealthy clients. Instead, the line between victim and perpetrator was blurred. Middlemen like Littaye funneled billions of dollars to Madoff, even, in some cases, when they suspected he was engaged in questionable trading practices. In return, they reaped hundreds of millions of dollars in client fees.

Lower Returns

Wolfer says he heard of traders trying to replicate the split-strike conversion strategy Madoff told investors he used -- buying shares of large U.S. companies and entering into options contracts to limit the risk -- and getting far lower returns. He also says he heard Littaye and other middlemen talk about how Madoff may have used the knowledge he gained from his market- making firm, New York-based Bernard L. Madoff Investment Securities LLC, to get in and out of stocks ahead of market swings.

That’s front-running, a term usually applied to brokers’ trading for their own account -- and profit -- ahead of clients.

It’s also applicable to Madoff’s purported practice, says Peter Henning, a law professor at Wayne State University in Detroit and a former federal prosecutor.

“Front-running isn’t who’s getting the benefit; it’s who’s paying the price,” says Henning, noting that Madoff’s market- making customers expected the firm to obtain the best price available when buying or selling stocks. Instead, their interests were apparently subordinated to those of Madoff’s investment clients.

Front-Running

While front-running is illegal, it didn’t horrify Madoff’s champions.

“They were convinced that the risk was only that the Securities and Exchange Commission would do something about breaches of the Chinese wall in the Madoff organization,” Wolfer says. In the worst case, he says, “what could be expected was that at a certain point the SEC could say stop.”

It was obvious to anyone who looked that something fishy was going on with Madoff's trades:

"An executive at a fund of funds that invested in Kingate says he once examined Madoff’s trading records to see whether they reflected the stocks’ publicly reported activity. He found Madoff consistently bought stocks at their lows and sold them at their highs.

The executive, who wouldn’t be identified, says he reported back to his boss that he thought Madoff was front-running his clients. He says the boss’s reply was 'Yeah, so what? That’s his edge.'"

Why did the manager's of these feeder funds turn a blind eye to what appeared to be blatantly illegal activity and take such risks with their clients' money? Answer, they were raking in huge fees in return for being Madoff's willing accomplices:

"If a fund charged its clients 1 percent of the assets under management and 20 percent of the gains, as the largest one did, that translated into $41 million in annual fees.

Assuming Madoff didn’t do any investing on behalf of his clients, as investigators now suspect, the feeder funds were, in effect, being paid out of principal, which would have been depleted after 15 years.

In other words, much of the money invested in Madoff through feeder funds wound up in the pockets of fund managers."

Barry Ritholtz of the Big Picture is right in part when he says that the Trustee should "confiscate the Funds of Fund managers’ houses, cars, watches, jets and boat — as the illegal proceeds of a crime. Auction ‘em off, put the proceeds into a fund for the scam’s victims."

But the investors don't have to wait for the Trustee to act, and many are not:

"Chais’s Brighton Co.; Bank Medici, which was taken over by Austrian regulators; Fairfield Greenwich; Merkin’s funds; and Tremont have all been sued by investors claiming the firms should have known better than to invest with Madoff."