For Schwab, it's damage control

Looks to calm fears of advisers exposed to subprime crisis through HighYield fund

Dec 17, 2007 @ 12:01 am

By Brooke Southall

Charles Schwab Corp. is working hard to allay the fears of financial advisers who were exposed to the subprime crisis through one of its own funds. The San Francisco-based broker held tightly controlled conference calls every day for advisers starting Nov. 26 after the net asset value of the HighYield Plus Select Fund (SWYSX) tumbled an additional 0.97% (bringing the total decline to 6% for the previous 12 months) that day on write-downs of its holdings by Interactive Data Corp. of Bedford, Mass., according to Sondra Harris, a spokeswoman for Schwab. The Schwab conference calls restricted advisers to submitting questions by e-mail. This serial hand-holding program for advisers by Kim Daifotis, chief investment officer and portfolio manager of Schwab's fixed-income products, will continue this week but will be cut back to every other day, Ms. Harris said. "We're doing it because we're getting questions," she added. "This is a dense, confusing subject." It's also forcing Schwab to walk a tightrope, industry analysts said. Schwab needs to explain to advisers how it got their clients entangled in subprime mortgages without seeming to point fingers at advisers themselves they said. "For Schwab, they're relying on the advisers to come back for more product," said Alois Pirker, an analyst with Aite Group LLC of Boston. "[Schwab doesn't] want to say, 'Sorry, it's your fault'" for blundering short-term cash into a longer-term product.

Yet this kind of misuse of the fund suggests that advisers are most at fault if their clients are forced to sell HighYield at a loss, said analysts and advisers.

"There hasn't been enough light shined on whether advisers have an interest" in taking on excess risk, said Peter Crane, editor of Money Fund Intelligence of Westborough, Mass. "Nobody gets paid to put investors in cash," he said.

The blame is on advisers' due-diligence efforts, not Schwab, according to Norman Boone, president of Mosaic Financial Partners Inc. of San Francisco, which manages $350 million, and Jim Ferrare, senior vice president of Pinnacle Associates Ltd. of New York, which manages $4 billion. Both invest in HighYield.

This is the only fair view to take, said Matthew Wright, investment manager for Wade Financial Group Inc., which manages $160 million from Minneapolis. The firm also invests in HighYield.

"I'm not seeing a place to blame on Schwab," he said. "If we choose an active manager, we're going to go with them" and bear the consequences if they stay within their mandate.

Schwab could still end up with egg on its face, several analysts said.

"Advisers could argue [that] it looked like a money market fund," Mr. Crane said.

Mr. Pirker agrees.

"In hindsight, Schwab probably would have put more warning signs on [YieldPlus]," he said. "They are probably on solid ground legally, but it's [their reputation] that they have to worry about."

This is particularly true considering that Schwab is making a big push into proprietary products in general, said Timothy Welsh, president and founder of Nexus Strategy LLC of Larkspur, Calif., and a former marketing director of Schwab Institutional.

The problem for Schwab is that HighYield Plus had about 5% of its portfolio invested in subprime-mortgage-backed securities as of its most recent disclosure, according to the company.

This subprime position is one reason IDC re-priced the bonds held in the fund's portfolio, Mr. Daifotis said during a Dec. 4 conference call.

This re-pricing was a case of the chickens' coming home to roost after advisers earned higher returns with impunity for years, Mr. Crane said.

HighYield Plus and like cash alternatives soared in popularity with advisers starting in 2003 when money market rates bottomed out at around 1% and their clients were begging for more income.

Even now HighYield Select shares pays about 6.06%, versus 4.5% on Schwab Cash Reserves (SWSXX), the company's default sweep money market fund.

Schwab is not alone in confronting NAV declines in its short-term cash products.

The Fidelity Ultra Short Bond Fund (FUSFX), offered by Fidelity Investments of Boston, has suffered even greater losses than Schwab's HighYield Plus fund when its higher yield is factored in, Ms. Harris said.

Fidelity declined to comment on the concerns of its advisers over the fund's drop in NAV.

But its assets are substantially less than $1 billion, which makes the decline more of a non-event, according to analysts.

HighYield had more than $13 billion of assets at its high-water mark in June, though a rash of redemptions and value erosion had reduced that amount to $8.4 billion as of Nov. 27, Schwab's Ms. Harris said.

TD Ameritrade Holding Corp. of Omaha, Neb., avoided problems because it produces no bond funds, company spokesman Jim Frawley said.

This week, Bank of America Corp. of Charlotte, N.C., announced plans to close and liquidate its $12 billion Columbia Strategic Cash Portfolio, which also offered a higher yield than money funds in exchange for taking greater risks.

Schwab is going to take a more patient approach

The good news is that none of the bonds held by YieldPlus defaulted, and its managers have sufficient liquidity not to sell positions at a loss, Mr. Daifotis said

But the bad news is that Schwab can offer no assurances about when investors can unload the fund again without taking a hit, Mr. Daifotis added during the Dec. 4 conference call.

"As for regaining that NAV back, it's impossible to give a timeline whether it's 12 months or 18 months," he said.

Brooke Southall can be reached at bsouthall@crain.com.

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