How screwy is the world of high finance? So much so, that bond fund managers who should be investing exclusively in bonds, are now loading up on stocks.
According to latest portfolio disclosures, a total of 352 mutual funds classified as "bond funds" by Morningstar now own stocks. That's up from 283 in the first quarter of 2012.
What business do bond mutual funds have owning stocks?
It's a classic symptom of a rogue practice called "style drift," where fund managers plow into securities that are distinctly opposite of the mutual fund's actual name or the fund's investment objective. "Value funds" owning growth stocks is just one common example of style drift.
Shame on the SEC
Instead of outlawing this type of misleading activity, the Securities and Exchange Commission (SEC) actually encourages it. The SEC permits mutual funds to invest up to 20% of their assets in securities that don't necessarily match how a fund is labeled. And that's how mutual fund investors end up with bond funds that own stocks.
Here are a few real life examples of how the SEC allows fund companies to mislead the public:
The Pacific Advisors Government Securities fund (PADGX - News) had 18.19% of its portfolio invested in stocks like AT&T, McDonald's, and Microsoft as of its latest 3/31/13 disclosure. Government bond funds should not be allowed to own stocks! Yet, lax regulation permits Pacific Advisors to describe PADGX as a fund that's built for "conservative investors seeking high current income and some capital preservation."
Even heralded managers like Dan Fuss are style drifting. Look no further than the Loomis Sayles Bond Fund (LSBRX - News) which has 6.16% of its $22 billion portfolio exposed to stocks and preferred stocks.
"The number of bond funds that own stocks has surged to its highest point in at least 18 years," observed the Wall Street Journal in an article titled "Bond Funds Running Low on...Bonds."
Inaccurate benchmarking is another routine but rogue practice in the mutual fund industry.
Misleading Performance Results
Today's generation of fund managers cheat all the time. And one of their favorite ways to cheat is by comparing themselves to inaccurate hurdles.
Instead of truthfully comparing themselves to blended benchmarks or indexes as they rightly should, a portfolio manager holding 75% in stocks and 25% in bonds distorts their own actual results by comparing their fund's performance to a 100% all bond benchmark like the Barclays Capital Aggregate Bond Index (AGG - News).
The correct way to measure the performance of rogue bond fund manager holding 75% in stocks and 25% in bonds is to a blended benchmark of 75% to the Barclays Capital Aggregate Bond Index and 25% to a stock index like the Dow Jones US Broad Market Index (SCHB - News), assuming they don't own foreign stocks. And if they do, then add a foreign stock index to the blended benchmark mix, darn it!
If the SEC really wanted to do something right, it would require the fund industry to use blended benchmarks. But instead, it allows the fund industry's powerful lobby to hypnotize regulatory circles with bogus research about how it would harm fund shareholders.
In my book Gents with No Cents: A Closer Look at Wall Street (2011, Half Full Publishing), I likened the SEC's existence to the feathers on an ostrich. The feathers are there for merely decorative purposes, not to help the beast fly. Can you imagine what an already ugly bird would look like without feathers?
The Translation for Investors
For financial advisors and individual investors the message is clear: The foundation of investment portfolios should be index linked ETFs that strictly invest according to the asset classes they're supposed to track. This is a sure footed way to obtain an accurate asset mix that perfectly matches your goals and avoids hidden risks. Tolerating style drift is an absolute no-no.
It's also proof of how professional investors have fallen victim to the same adolescent behavior (performance and yield chasing) they accuse the amateur masses of having.
The May 2013 issue of the ETF Profit Strategy Newsletter examines the fundamental and technicals for ETFs linked to major asset classes. It includes our short list of mega investment themes along with our popular Technical Forecast that's updated several times per week.
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