A bond-fund manifesto

This article from Morningstar.com has generated a lot of interest in the US. It discusses the shortcomings of disclosure for fixed income funds. Investors in the UK and Europe have the same problem--in fact disclosure in markets here is arguably even lighter than in the US. This makes it difficult for investors to choose the right bond fund and existing investors often find it impossible to understand why their fund has performed well or badly. To read up on the five key concepts that every bond fund investor should know, read this article.

In moments of weakness, frustration can slip into anger. Like while sifting through pages of bond-fund reports and factless "fact sheets" trying to grasp a manager's strategy or what kind of market exposure a fund has. Forget about the shareholder letter providing anything useful. If you're lucky you might learn a little about why the fund performed the way it did…during a six-month period that ended two months ago. But detailed explanations of a fund's market bets, or what's driving a manager to make them, are often few and far between.

That opacity makes most bond-fund disclosures nearly useless to the average shareholder. It's true there's a lot of important information in those reports, and there's much more today than there used to be. But if you really want to know how and why a fund is positioned the way it is and what market risks it has, those materials are often woefully inadequate.

When the frustration subsides, it's easier to recall that this is not a conspiratorial plot. There are cases here and there in which shareholders seem to be deliberately left in the dark, but most of the time the explanation is more banal. Big shops with scores of funds have to turn out an array of materials at regular intervals for regulators, internal and external sales forces, and of course shareholders. That may require an entire operation with staffs to work on accounting, writing, design, and legal compliance. In that world, standardisation and consistency are prized. Detailed charts, graphs, and tables that require manual adjustment and frequent changes are anathema to the smooth running of that paperwork machine.

There may have been a time when grudging acceptance of that state of affairs seemed reasonable. If so, it ended when the financial crisis triggered shocking losses in some corners of the bond market, confounding fund investors who had no idea they were exposed to such risks.

A comprehensive wish list of disclosure reforms would run much longer, but here is a snapshot of five essentials.

1) Tell shareholders if their funds are leveraged
This is one of those anger triggers. Years ago finding an open-end mutual fund with leverage was like finding a needle in a haystack. Today they're a dime a dozen, but you have to know how to find them. You can learn how leveraged a fund is by digging deep into its financial disclosures, but good luck finding reference to it anywhere else, whether it's in your shareholder letter, on a fact sheet, or in an asset breakdown. Given the amount of added risk leverage can produce, that's infuriating. At some point, omission crosses over into deception.

2) Tell shareholders if their funds are leveraged…continued
Even if a fund hasn't actually gone out and borrowed money to create leverage, it can create leveraged exposures with derivatives. We found several that did so in 2008 without providing any meaningful explanation to shareholders. The futures and swaps creating those exposures were detailed deep in each fund's financial statements, but the information was almost universally more difficult to find than conventional leverage and just as absent from the graphs, tables, and shareholder letters one might otherwise rely on to understand a portfolio.

3) Provide an asset breakdown that's actually meaningful
The "correct" way to do this often depends on the kind of fund, but that's the point. A generic sector breakdown that sorts a portfolio into buckets like Treasury bonds, corporate bonds, and mortgages is nearly useless if the mortgage bucket comprises 50% of the fund and houses a mix of current-coupon Ginnie Mae pass-throughs, prepayment protected CMO tranches, a hunk of subprime paper, and manufactured housing debt. The chart for a national muni fund that breaks down by state is equally useless if it's chock-full of tobacco settlement, airline, and nonrated nursing home bonds.

4) Don't make me do the maths or send out a search party for the number
It's when a fund report has 15 pages of credit default swaps and no tally of the market exposure they represent that you start wondering whether someone really is trying to hide something. Ditto if they're not factored into a fund's credit quality and corporate sector exposure. We've yet to see such a list that shows what the actual underlying bonds (or reference entities) are and which market sectors they belong to. Arguably the worst number formatting slight-of-hand we've seen is the presentation of a fund's total investments with no reconciliation to net assets. In other words, no line item breaking out how many of those assets are borrowed (i.e. leverage), and how many are truly "net" assets. That's one number that has no business whatsoever being relegated to a footnote.

5) Tell me what my manager would want to know
This is the guts of it, and just an adaptation of Morningstar investment consultant Mike Stout's First Rule of Fund Analysis: What would you tell your mother? The manager of every fund is the one person who knows best what information you need to understand its strategy, what its market exposures are, and what kinds of risks it's taking. The information in a typical annual report doesn't come close. In fact, most managers use software packages and tracking systems that look at their funds through completely different lenses than those in public disclosures. Bottom line: If it's not good enough for the fund manager, then it's definitely not good enough for his boss. You know, the one that actually owns the fund.