Floyd Norris has a great column today taking Charles Schwab to task for its egregious behavior surrounding the ill-fated YieldPlus fund. Charles Schwab lied about the fund to the people who invested in it, and has not apologized for doing so: instead, the company just says that “we regret that fund shareholders lost money in YieldPlus.” Yeah, I’ll bet they do.
YieldPlus was Schwab’s largest bond fund—its real flagship in the fixed-income space, designed and marketed as a cash alternative. The company trumpeted its short duration and low weighted average maturity, but in fact the fund was investing in very long-dated instruments indeed: on Sallie Mae bond, for instance, didn’t mature until October 2021.
Schwab used two tricks to avoid telling investors just how long-dated the YieldPlus bond portfolio really was. One of them was to quietly stop talking about weighted average maturity, and start talking instead about modified duration. This is from the SEC complaint. (Warning: that link will take you to a 6MB PDF, created by scanning pieces of paper. Come on, SEC, you can do better than that.)
A fund’s weighted average maturity (“WAM”) is a measurement of the average length of time until the underlying bonds in a portfolio mature. WAM can be used by investors to evaluate the riskiness of a product; among similar funds, those with a longer WAM generally involve more risk. A fund’s duration is different than WAM; duration is a mathematical measure of a fund’s sensitivity to interest rate risk, but is not a measurement of time. For the relevant period, the YieldPlus Fund’s duration was a lower number than its WAM.
Between February 2006 and September 2007, in some communications with investors, Schwab substituted the Fund’s duration for its WAM, in some instances without noting the change. The resulting understatement appeared in sales and marketing materials and one Commission filing…
In early 2006, the YieldPlus Fund’s WAM increased significantly… CSIM and CS&Co. then listed the Fund’s duration in place of its WAM in the sales materials, including tables that listed statistics for all Schwab’s funds and, internal daily reports. Schwab did not replace WAM with duration for any other fund.
In some communications, CS&Co. and CSIM noted the replacement with a footnote indicating that duration, not WAM, was listed. However, in tables on the Schwab.com website, one Commission filing, and two issues of On Investing magazine, CS&Co. and CSIM did not include the footnote. As a result, for eighteen months, the website indicated that the average maturity of the Fund’s bonds was six months when the Fund’s WAM actually ranged from at least 1.3 to 2.2 years.
This is even more egregious than it sounds. It’s unclear to me exactly how Schwab was calculating the duration of the YieldPlus fund, but it looks as though the company went to great lengths to pick a calculation which measured only interest rate risk, rather than a more conventional measure. Bond duration is, as the excellent Wikipedia article on the subject says, the weighted average of the times until a bond’s fixed cash flows are received. In the case of floating-rate bonds it’s hard to measure duration accurately, since you don’t know how big certain future cash flows are going to be. But if you have bonds in your portfolio which don’t fully mature until 2021, you know that some weight has to be given to long-dated flows.
Duration is one way of measuring interest rate risk, but that’s not all duration does. It also gives one indication of market risk—the risk that the value of a debt instrument will fall. If it’s very unlikely that Sallie Mae will default in the next six months, then there’s a limit to how much the price of a Sallie Mae bond maturing in six months’ time can fall. On the other hand, if the bond just floats to a different interest rate in six months, then the price can fall a lot, since there’s still substantial default risk in the years ahead. So if you use a measure of duration which ignores maturity dates and just looks at interest-rate risk, then you’re leaving out a crucial piece of information—especially if at the same time you’re no longer giving out numbers for weighted average maturity.
But it gets worse than that. Norris explains that when Schwab did give out numbers for weighted average maturity, it was lying:
If an investor was worried about maturity risk, the 2007 annual report was reassuring. It said that on Aug. 31 of that year, more than 60 percent of the fund’s assets had maturities of six months or less. In the glossary at the back of that annual report, maturity was defined to mean just what it really means: “The date a debt security is scheduled to be ‘retired’ and its principal returned to the bondholder.”
But that was not what Schwab really meant. At the beginning of the list of investments held by the fund, it said that the maturity date shown for adjustable rate securities was “the next interest rate change date.”
There is no reason to do this, except that you want to deliberately mislead your investors into thinking that the fund is safer than it really is. Maturity is a measure of maturity, not a measure of the amount of time until a coupon resets. All this trickery with duration and maturity was designed with one purpose in mind: to lie to investors. Which Schwab did in other ways, too:
While the YieldPlus Fund’s NAV declined, CSIM, CS&Co., Merk, and Daifotis held conference calls, issued written materials, and had other communications with investors that contained a number of material misstatements and omissions concerning the fund. For example, in two conference calls, Daifotis made false and misleading statements that the fund was experiencing “very, very, very slight” and “minimal” investor redemptions. In fact, Daifotis knew that YieldPlus had experienced more than $1.2 billion in redemptions during the two weeks prior to the calls, which caused YieldPlus to sell more than $2.1 billion of its securities. Similarly, Merk authored, reviewed and approved misleading statements about the fund, such as a false claim that the fund had a “short maturity structure” that “mitigated much of the price erosion” experienced by its peers.
As Norris says, this kind of behavior flies in the face of Schwab’s ostensible commitment to be “on the side of the investor”: it’s not only illegal, as the company’s $118 million settlement with the SEC suggests, but it also destroys the main selling point which Schwab uses to differentiate itself from other brokers.
Schwab clients should I think pay great attention to the fact that the company has expressed precious little remorse over its actions surrounding YieldPlus, and indeed has started pointing fingers instead at “the investment banks that created mortgage-backed securities and the ratings agencies that legitimized them with triple-A ratings”. That says to me that Schwab’s culture hasn’t changed, and that investors in its funds can’t trust what they’re told. The company might be a good discount brokerage. But it’s not a respectable fund manager.