Fund-Investor Lawsuits Spur Controversy
Sarah Rosen lost money in a bond mutual fund in 1994, and now she’s suing to get it back.
But unlike most of the suits that have been filed by disgruntled fund shareholders reeling from the worst bond market losses in this century, Rosen isn’t alleging that a pushy broker sold her something she didn’t understand.
Rather, Rosen’s complaint against giant Fidelity Investments essentially constitutes a sharp disagreement over the type of bonds it chose for her fund, and how the firm calculated and disclosed the risk level of those bonds.
The class-action case, filed in a Pennsylvania state court, is an example of a disturbing trend in litigation against investment firms, some analysts say: Instead of claiming complete ignorance about a fund’s risk--the “Orange County defense”--some shareholders are in effect attacking fund managers’ investment decisions as inappropriate or unwise, and seeking reimbursement of loss on that ground.
Critics of such suits say they represent nothing more than second-guessing of entirely legal fund strategies, and smack of some investors’ unwillingness to accept that in free markets you can lose money as well as make it.
The potential effect of such suits on the fund industry, some analysts say, could be to frighten many portfolio managers into a risk-aversion mode that would be an invitation to sustained mediocrity in fund returns.
“Managers dogged by lawsuits can only take refuge in the assumption that no one can complain as long as they invest in the same stocks and bonds as everyone else,” warns Amy C. Arnott, associate editor of Morningstar Mutual Funds, in an essay entitled “Lawsuits Run Amok” in the newsletter’s Feb. 17 issue.
Rosen’s attorney, Michael Donovan, argues that their case isn’t sour grapes, but rather is a classic example of a fund promising one thing and delivering another, to the detriment of investors.
Here’s the background:
* Rosen, a retiree in Wynnewood, Pa., said she cashed $11,438 out of a bank savings certificate in December, 1993 to buy 1,155 shares of the Fidelity Spartan Short-Intermediate Government Fund. She said she was attracted by the fund’s stated goal of providing “high current income consistent with preservation of capital.”
* Unlike many fund owners, Rosen claims to have read and understood the fund prospectus, which said the fund would maintain a portfolio of bonds with an overall “average maturity” of two to five years. By holding to that relatively short time frame, the fund expected to limit the vulnerability of its principal to rising interest rates, which devalue older bonds.
* As market rates surged in the first half of 1994, the value of Rosen’s shares declined, as did most bond funds’ shares. What apparently shocked Rosen, however, wasn’t the extent of the decline but what she saw in the list of the fund’s bonds in the April 30, annual report mailed to her that spring.
Rosen “was surprised to learn that the majority of the fund’s assets had been invested in long-term mortgage-backed securities, as opposed to securities with maturities of two to five years as the fund’s name implies,” the suit says.
* In a series of letters to Fidelity last summer, Rosen argued that the portfolio was inconsistent with the fund’s stated objective of maintaining a two- to five-year average maturity. Despite Fidelity’s written rebuttals to the contrary, Rosen continued to take issue with the portfolio. Unable to get what she considered a satisfactory explanation, she sold her shares in October at a loss--and then sued.
Did Fidelity’s inclusion of very long-term bonds in the portfolio take the fund out of its advertised two- to five-year maturity range, leaving it more susceptible to devaluation by rising rates?
Fidelity says no. Rosen says yes. Disinterested parties may view the conflict as so much hair splitting.
The long-term mortgage-backed bonds in the fund, while in some cases officially maturing in 30 years, in practice would mature much faster, Fidelity notes. That’s because most Americans change houses periodically and thus retire their mortgages early.
But to calculate an average maturity for such bonds, you have to make an assumption about how fast the mortgages will be paid off. Central to Rosen’s suit is the claim that Fidelity used the “most aggressive” assumption about mortgage payoffs--and that the firm failed to disclose that in the normal literature received by investors.
Only by requesting certain arguably obscure fund documents could an investor begin to grasp the process by which Fidelity could hold so many 30-year bonds in a “short-to-intermediate” term fund, Rosen contends.
For its part, Fidelity says its process was nothing unusual, and that the fund’s average maturity in fact never topped five years. “Shareholders got exactly what they paid for,” Fidelity spokeswoman Marilyn Morrison says.
Moreover, the fund’s bottom line seems to back that up: Its total return for 1994 was a negative 0.5%, which was substantially less than the 1.7% loss of the average fund in its peer group, according to fund-tracker Lipper Analytical.
Since short-term bonds perform better than long-term bonds in an environment of rising interest rates, the fund’s relatively small loss would suggest that the portfolio didn’t exceed its stated maturity range. As calculated by Lipper, the average long-term government bond fund lost 4.6% last year.
Donovan, however, is undeterred. The risk profile of the fund was such that “the portfolio doesn’t even come close to having a short- or intermediate-term maturity,” he argues. He is seeking dissolution of the fund and the return of all shareholders’ money in full.
Can a case like this one succeed? Normally, a fund company’s defense relies not on the fund’s performance, but on whether it invested the way it said it would.
“What is disclosed in the prospectus and in sales materials is considered to be binding on the fund,” says Kathryn McGrath, attorney at Morgan, Lewis & Bockius in Washington.
Fidelity clearly spelled out all of the bonds it might buy. What it didn’t explain in any detail was how it mixed those bonds together to get a relatively short-term average maturity.
There was a time, however, when that kind of decision was considered the exclusive domain of the portfolio manager. The details were supposed to be left to that professional, for better or worse. Why else hire a fund?
If Rosen is right, and the end performance of the Fidelity fund didn’t justify the means it took to get there, it raises serious questions about the independence of fund managers--and their traditional right to reasonable leeway in the search for decent returns.
“If what she’s saying is that they (Fidelity) used bad judgment, well, that’s the nature of the investment” process, says Michael Lipper, head of Lipper Analytical. The manager is paid to judge, but is not required by law to judge correctly.
