Lessons from Schwab's YieldPlus Debacle

Last week Charles Schwab agreed to pay $200 million to settle a lawsuit filed by investors in its YieldPlus fund. The investors claimed that they had been misled about how risky the fund was. Schwab claimed that the fund was expected to provide "good returns with low principal risk." But despite that claim, the fund posted a cumulative loss of -42 percent in 2008-2009.

So what lessons should investors take from this?

1. You can't always trust your fund manager. According to the complaint in this case, YieldPlus was marketed as "a smart alternative for your cash," and Schwab's customer service representatives were trained to push the fund as an alternative to lower-yielding CDs and money market funds. Investors following this advice boosted the fund's total assets to a high of $13.5 billion, and provided hundreds of millions of dollars of fee revenue to Schwab over the years. When the credit markets first started showing signs of trouble in the late summer of 2007, Schwab posted an "FAQ" about the fund on their website. There, they assured investors that "less than 0.0001% of [the fund's] total assets are invested in sub-prime securities that do not have an investment-grade rating." While that might have been comforting at the time, investment-grade ratings on sub-prime securities proved to be about as useful as suntan lotion in a blizzard. The fund's holdings -- investment-grade and all -- got hammered in the credit meltdown.
2. You can't always believe the analysts. In May 2007, Morningstar's analysis of YieldPlus carried the headline "YieldPlus a Solid Alternative to Cash." In November, they wrote that they were "guardedly optimistic about [the fund's] prospects." Just nine months later, with the fund sporting a 31 percent loss, Morningstar's optimism was exhausted, and they accurately called the fund "an unmitigated disaster."
3. You can't always rely on the media. In mid-2007, USA Today highlighted YieldPlus as one of "5 Bond Funds Worth Keeping," noting that in its then-eight year history it had never lost money over a 12 month period. But if such lack of foresight is forgivable on the eve of a crisis the likes of which we had never seen before, a disinterest in the fund's now-clear failure is less so. A few weeks ago, Money magazine's Lisa Gibbs blogged about the YieldPlus lawsuit, writing that she found it a "particularly problematic episode for Schwab" that was "surprisingly underpublicized." I would agree on both counts. But it's hard to reconcile those comments with the extensive profile of Schwab she wrote just a few months earlier in the January issue of Money. The article logged in at over 2,000 words. Of those, just 61 words at the end touched upon YieldPlus. No mention was made of the losses investors had suffered. Nor was it noted that this fund's assets -- which once topped $13 billion -- were now less than $200 million. Ms. Gibbs did, however, quote new Schwab CEO Walter Bettinger, who said "we feel horrible." Well, that's nice.
4. There is no free lunch. No matter what any fund manager or investing expert tries to tell you, the iron law of investing remains in force: risk and return are inextricably linked. There is no more competitive terrain in the entire world than the financial markets -- no one is interested in giving money away. If one of the market's participants is offering you what appears to be a higher return, rest assured that it is accompanied by increased risk. Sometimes, as was the case with YieldPlus, that risk may not manifest itself for long stretches of time. But make no mistake, it remains present, and will eventually make itself known.