Charles Schwab Corp. of San Francisco is facing a potential class-action lawsuit over no-load ultra short bond fund that allegedly loaded up on mortgage-backed securities and misled investors.
In a lawsuit filed March 18 in U.S. District Court, Northern District of California, lead plaintiff and Schwab fund investor Mike Labins alleges that the Schwab YieldPlus Fund he purchased was portrayed as a higher-yielding alternative to a safe, liquid Schwab money market fund.
Both of the YieldPlus Fund's two share classes, however, concentrated their holdings in mortgage-related securities, had inflated NAVs and were overly defiant of risk, according to the lawsuit.
The Berkeley, Calif., office of Hagens Berman Sobol Shapiro, filed the suit against Schwab Corp., and its investment management unit, along with namesake and founder Charles Schwab, as well as three Schwab fund execs. No board members were named as defendants.
The lawsuit, which plaintiff's lawyers hope will be granted class-action status, includes Labins and all other fund shareholders who acquired the fund between March 17, 2005 and March 17 2008.
Safe for the Money'
The suit charges the net asset values of the fund's two "investor" and "select" share classes began tumbling precipitously when the bottom began to come out from under the subprime mortgage market, and then the banking credit system, with the current morass and mayhem now ensuing in the investment banking, stock and mergers and acquisitions markets.
The original stated objective of the Schwab YieldPlus Fund was simply to seek high current income with minimal change in share price. Moreover, the fund stated that it invested in a large, well-diversified portfolio of taxable bonds. According to the lawsuit, neither of those facts were true.
The fund's shares had been steadily trading at about $9.70 per share but began plummeting in July 2007, bottoming out, so far, to a low of $7.95 on March 17, 2008, a loss of 18% since June, the lawsuit claims. The culprit: the fund's overconcentration in mortgage and mortgage-related securities. Despite promises of being a widely diversified fund, at one point the fund had over 50% of its assets in the mortgage sector of the market, the court documents charge.
"The most egregious point was that it [Schwab YieldPlus] was being sold as a cash fund alternative. Everyone we spoke to believed this was safe for the money they would use for retirement, or when they were out of the stock market, or to pay bills with," said Reed Kathrein, a partner with Hagens Berman.
"How can they say putting so much into mortgages is highly diversified?" Kathrein asked. "Why not call it the short-term mortgage-backed instrument fund and let people know what they were buying?"
Schwab characterizes the lawsuit and its litany of charges as frivolous. "Schwab believes the allegations of the lawsuit are without merit and that the fund's prospectus met the legal requirements," said Schwab spokeswoman Sondra Harris. "Schwab intends to defend against the lawsuit, and in the meantime, we'll continue to manage this fund in the best interest of clients."
Schwab may be the latest firm to feel the heat from investors' losses, but it isn't the only investment manager that has either piled or selectively included mortgage-related securities into its funds.
While the Schwab YieldPlus investor class and Schwab YieldPlus select class lost a whopping 18.62% and 18.50%, respectively, over the past 12 months through March 25, according to Morningstar, the SSgA Yield Plus Fund managed by State Street Global Advisors of Boston fared the worst, declining 25%-plus in value over the same one-year period (please see the accompanying chart).
A SSgA spokeswoman had not returned a call at press time seeking comment. But Morningstar portfolio data shows that as of the first day of March, more than one-third of the fund's $28 million in assets (37%) was invested in collateralized mortgage obligations.
Schwab and SSgA are in good company. Ultra-short bond funds from Dreyfus Corp., PIMCO, Principal Investors and even Fidelity Investments have posted losses ranging from 6.8% to as much as 11.2%. That compares to the average return among all ultra-short bond funds over the same period of -0.37%.
The Principal Investors Ultra Short Bond Fund, Class A, had almost 46% of its $200 million portfolio invested in mortgage-related securities at last take, according to Morningstar. A company spokesperson had not returned a call seeking comment.
"Like other fixed-income funds, the Fidelity Ultra Short Bond Funds have faced a challenging market environment," said a Fidelity spokesperson, adding that the funds are run by a portfolio manager with more than two decades of experience. While Fidelity's investment tactics continue to evolve, the firm is deeply committed to its underlying investment process and the fundamental research that goes with that, he added.
Unprecedented Fund Losses'
"A lot of this has been due to subprime-related mortgages," acknowledged Scott Berry, associate director of fund analysis at Morningstar. "It's unprecedented," he added. "We've never seen losses like this before."
Just as April showers bring May flowers, industry experts predict mounting fund losses will produce a more investor lawsuits and arbitration claims. There will, however, be plenty of smaller investors who have not lost enough money to make it worthwhile for lawyers to file claims, said one plaintiff's attorney.
$30M in Losses-So Far
Two potential class-action lawsuits and several FINRA arbitration claims remain against Morgan Keegan & Co., the Memphis, Tenn., investment management subsidiary of Regions Bank of Birmingham, Ala., whose Morgan Asset Management unit manages both open-end and closed-end bond funds. This past December and January a flurry of complaints alleged that fund managers had loaded their portfolios with mortgage-backed securities that well exceeded the regulatory sector and illiquid security limitations [see MME 1/14/08].
A trio of attorneys are currently vying for the right to represent a court-chosen lead plaintiff in this case. Arbitration claims are also mounting and now represent about $30 million in lost assets across several dozen fund investors, said Chicago-based plaintiff attorney Andrew Stoltmann.
But Morgan Keegan has clearly cleaned house; a likely attempt to show the now-probing Securities and Exchange Commission that Morgan Keegan takes this seriously, Stoltmann added. Two top executives at the firm have retired or plan to retire, including the chairman and ceo/president. A company spokeswoman declined comment.
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