How Schwab misled investors

The company played around with 2 key measurements, making one fund look more stable than it really was.

By Kim Peterson Jan 14, 2011 2:40PM
Fine print © JupiterimagesYou just don't expect bad behavior from Charles Schwab (SCHW). The guy even wrote a letter on his website saying, "I'm on the side of the investor." He's not vampire squid material, is he?

An investigation and charges from the Securities and Exchange Commission show an altogether different side of Schwab's company. Schwab did some bad things with one mutual fund, its YieldPlus, and two executives were charged with fraud and other securities violations.

The lesson from YieldPlus is a good one for any investor. Here's how Schwab went from "on our side" to misleading clients:  

Schwab sold the fund as a "cash alternative," an ultra-short bond with a higher yield than a money market fund, the SEC says. Above all, Schwab wanted to get the message across that YieldPlus was safe. It's value would see only minimal fluctuations, and it was just a tiny bit riskier than CDs and other cash alternatives.

For someone looking to park cash, this would have been an attractive investment. Here's where things went bad. Schwab played around with two measurements that are hugely important to investors: the fund's weighted average maturity and its duration.

Weighted average maturity is the average time it takes for the bonds in a portfolio to mature. By 2006, the weighted average maturity had jumped to more than one to two years. More time means more risk, and that didn't jibe at all with the "cash alternative" spin Schwab had put on the fund.

So what did Schwab do? It booted the maturity number and substituted the duration figure in its place. Duration has nothing to do with time but instead shows how sensitive a fund is to interest-rate changes.

As a result, the fund looked like it had an average bond maturity of six months, not 1.3 to 2.2 years.

Cut to the credit crisis in 2007, and investors dumped YieldPlus as its value started to drop. Well, if the average maturity had actually been six months, it would have been easier for Schwab to recover cash for investors who wanted out.

But only 6% of the fund's assets were scheduled to mature in six months. So the fund had to sell assets at a steep loss to get enough cash. So many people fled that its assets dropped by 95% (from $13.5 billion) in just one year. Investors lost billions.

That fund still exists, and The New York Times reports that Schwab now describes it as a "high risk with low return" investment. Sounds great, right?

Charles Schwab is paying more than $118 million to fix this, but the case continues against the executives. You can read the SEC's entire complaint here against the company.

What to take away from this? Be very aware of a fund's weighted average maturity and duration. But know that even then, the numbers may not be what they appear.
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