|
Introduction to the Fund
The YieldPlus Fund is an open-ended mutual fund organized as a Massachusetts business trust registered under the Investment Company Act. It has issued two series of securities: Investor Shares (“SWYPX”) and Select Shares (“SWYSX”). Select Shares have a minimum purchase requirement – $50,000 as compared to $2,500 for Investor Shares.
Schwab, in its marketing and advertising materials, on its website, on television and elsewhere, touted the YieldPlus Fund, as a safe, money market or near cash, security. By way of example, these representations include:
• Increase Your Income Potential Without Taking on Significantly Higher Risk.
It’s Smart to be concerned about your fixed income investments, considering current economic factors. Rising interest rates and inflation mean returns may not be keeping pace, and taxes are always a factor.
• If you seek higher yields without assuming too much Risk:
Consider the Schwab YieldPlus Fund.
• Discover A Smart Alternative for Long Term Cash Holdings
Looking for a way to earn better yields on your long-term cash without taking on significantly higher risk? The Schwab YieldPlus Fund seeks to benefit from the current rising-rate environment and can be a smarter alternative to investing in money market and long term bond funds.
Increased yield potential – Ultrashort bond funds like the Schwab YieldPlus Fund have historically provided higher sustained yields versus money market funds, as their short duration helps minimize exposure to falling bond prices as interest rates rise. Even though the share prices may fluctuate minimally, these funds offer lower risk than longer-term bond funds and only marginally higher risk than money market funds.
(Schwab Website January 2006)(emphasis added).
• The Schwab YieldPlus Fund
Goal and Strategy
This fund seeks high current income consistent with minimal changes in share price. The fund primarily invests in corporate, mortgage backed, asset backed debt securities and collateralized mortgage obligations. The fund seeks to keep its average duration at one year or less.
The Fund is designed to offer:
• monthly current income from a diversified portfolio comprised of primarily investment grade bonds, with some lower quality bonds for incremental yield.
• limited exposure to interest rate risk by maintaining an ultra-short average duration, resulting in lower share price fluctuation.
• the benefits of extensive credit research and professional money management.
(Schwab Fact Sheet March 31, 2006)(emphasis added).
• Discover A Smart Alternative for Long Term Cash Holdings
Looking for a way to earn better yields on your long-term cash without taking on significantly higher risk? The Schwab YieldPlus Fund seeks to benefit from the current rising-rate environment and can be a smarter alternative to investing in money market and long term bond funds.
Increased yield potential – Ultrashort bond funds like the Schwab YieldPlus Fund have historically provided higher sustained yields versus money market funds, as their short duration helps minimize exposure to falling bond prices as interest rates rise. Even though the share prices may fluctuate minimally, these funds offer lower risk than longer-term bond funds and only marginally higher risk than money market funds.
(Schwab Website April 2006)(emphasis added).
• The Schwab YieldPlus Fund
Goal and Strategy
This fund seeks high current income consistent with minimal changes in share price. The fund primarily invests in corporate, mortgage backed, asset backed debt securities and collateralized mortgage obligations. The fund seeks to keep its average duration at one year or less.
The Fund is designed to offer:
• monthly current income from a diversified portfolio comprised of primarily investment grade bonds, with some lower quality bonds for incremental yield.
• limited exposure to interest rate risk by maintaining an ultra-short average duration, resulting in lower share price fluctuation.
• the benefits of extensive credit research and professional money management.
(Schwab Fact Sheet September 30, 2006)(emphasis added).
• Discover A Smart Alternative for Your Cash
Looking for higher yields on your long-term cash with minimal exposure to interest rate risk?
The YieldPlus Fund offers:
High Yields – As you consider alternatives for your cash, this actively managed ultra-short bond fund offers a history of solid returns and attractive SEC yields.
Minimal Interest-Rate Risk – YieldPlus is managed to help minimize exposure to interest rate risk. Its share price (NAV) has fluctuated by no more than $0.04 (between $9.65 and $9.69 over the year ending 12/31/2006, giving it the relative stability necessary in today’s market.
(Schwab Website January 2007)(emphasis added).
Schwab so touts that for every year, since inception, the The Schwab YieldPlus Fund has outperformed the Lipper Ultrashort Bond Fund Category Average, and that the Fund earned a Morningstar� � five-star overall rating.
On May 16, 2007, YieldPlus Fund Co-Manager, Matt Hastings, appeared on Bloomberg Television, characterizing the Ultra-short term bond fund, as investing in high quality securities, and that the Fund’s objective, specifically was to “capture money fund investors.” During this same interview, Hastings attempted to downplay, the Fund’s exposure to subprime mortgages and the Fund’s investment in the securities of Countrywide Financial, by stating that Countrywide was an industry leader, and that the Fund’s assets were not concentrated in the securities of any particular industry, economic sector or industry.
As stated above, the Yield Plus Fund, purports to be “an ultra short-term bond fund, designed to offer high current income with minimal changes in share price. The fund seeks to keep the average duration of its portfolio at one year or less.” In the Fund’s Registration Statement dated, November 2004, and the Fund’s “Statement of Additional Information,” referenced in the Registration Statement, and not included in the Fund Prospectus, Schwab, with respect to “Investment Limitations,” stated that:
THE SCHWAB YIELDPLUS FUND AND THE GNMA FUND MAY NOT:
1) Invest more than 15% of its net assets in illiquid securities.
2) Purchase securities of other investment companies, except as permitted by the 1940 Act, the rules or regulations thereunder or any exemption therefrom, as such statute, rules or regulations may be amended or interpreted from time to time.
3) Sell securities short unless it owns the security or the right to obtain the security or equivalent securities, or unless it covers such short sale as required by current SEC rules and interpretations (transactions in futures contracts, options and other derivative instruments are not considered selling securities short).
4) Purchase securities on margin, except such short-term credits as may be necessary for the clearance of purchases and sales of securities and provided that margin deposits in connection with futures contracts, options on futures or other derivative instruments shall not constitute purchasing securities on margin.
5) Borrow money except that the fund may (I) borrow money from banks or through an interfund lending facility, if any, only for temporary or emergency purposes (and not for leveraging) and (ii) engage in reverse repurchase agreements with any party; provided that (I) and (ii) in combination do not exceed 33 1/3% of its total assets (any borrowings that come to exceed this amount will be reduced to the extent necessary to comply with the limitation within three business days).
6) Purchase securities (other than securities issued or guaranteed by the U.S. government, its agencies or instrumentalities) if, as a result of such purchase, 25% or more of the value of its total assets would be invested in any industry or group of industries.
Schwab Statement of Additional Information, Nov. 15, 2004.
As of May 31, 2005, in Form N-Q disclosing the YieldPlus securities holdings, Schwab reported that the YieldPlus Fund, valued at approximately $5 billion, consisted of:
Holdings By Category Cost (000) Value (000)
45.5% Corporate Bonds $2,302,415 $2,304,061
30.1% Asset-backed Obligations 1,515,797 1,521,636
15.8% Mortgage-backed Securities 799,756 799,841
0.0% U.S. Government Securities 1,161 1,161
1.8% Commercial Paper & Other
Corporate Obligations 93,500 93,500
6.9% Preferred Stock 352,537 351,275
0.1% Other Investment Companies 3,242 3,242
===== =====
100.2% Total Investments $5,068,408 $5,074,716
Schwab YieldPlus Form N-Q, May 31, 2005.
Again, in the Statement of Additional Information, dated, September 15, 2006, as referenced, but not contained in the Schwab Yield Fund Prospectus, the Company stated that:
CONCENTRATION means that substantial amounts of assets are invested in a particular industry or group of industries. Concentration increases investment exposure. For purposes of a fund's concentration policy, a fund will determine the industry classification of asset-backed securities based upon the investment adviser's evaluation of the risks associated with an investment in the underlying assets. For example, asset-backed securities whose underlying assets share similar economic characteristics because, for example, they are funded (or supported) primarily from a single or similar source or revenue stream will be classified in the same industry sector. In contrast, asset-backed securities whose underlying assets represent a diverse mix of industries, business sectors and/or revenue streams will be classified into distinct industries based on their underlying credit and liquidity structures. A fund will limit its investments in each identified industry to less than 25% of its total assets.
Schwab Statement of Additional Information, Sept. 15, 2006.
As of November 30, 2005, in Form N-Q disclosing the YieldPlus securities holdings, Schwab reported the Fund’s investments included:
Holdings By Category Cost (000) Value(000)
39.9% Corporate Bonds $2,450,952 $2,449,888
32.0% Asset-backed Obligations 1,959,164 1,962,684
23.2% Mortgage-backed Securities 1,945,447 1,906,027
0.1% U.S. Government Securities 5,387 5,387
0.8% Commercial Paper & Other
Corporate Obligations 46,983 46,983
4.6% Preferred Stock 284,943 286,202
0.1% Other Investment Companies 1,815 1,815
===== ========
100.2% Total Investments $6,194,868 $8,178,892
Schwab YieldPlus Form N-Q, November 30, 2005.
B. Yield Plus Fund : A Subprime Transformation
In 2006, the YieldPlus Fund internal auditors were fired, possibly for cost-cutting reasons. Also, in 2006, Sheldon D. Engler Ph.D., Vice President and Head of Fixed Income Research, of Schwab Management, Inc., who managed the team responsible for credit analysis and investment selection for Schwab’s money market and bond funds, walked out and was not replaced.
As of May 31, 2006, in Form N-Q disclosing the YieldPlus securities holdings, which had grown to approximately $7 billion, Schwab, for the first time reported that more than 25% of the YieldPlus Fund consisted of Mortgage Backed Securities, and that the Fund’s investments included:
Holdings By Category Cost (000) Value (000)
42.6% Corporate Bonds $2,909,373 $2,912,624
24.0% Asset-backed Obligations 1,643,814 1,645,057
27.9 Mortgage-backed Securities 1,945,447 1,906,027
0.1 U.S. Government Securities 5,466 4,466
2.9% Commercial Paper & Other
Corporate Obligations 200,759 209,759
3.1% Preferred Stock 208,111 209,718
0.1% Other Investment Companies 1,234 1,234
===== ========
100.2% Total Investments $6,914,204 $6,880,885
Schwab YieldPlus Form N-Q, May 31, 2006.
Also, in its September 15, 2006, Statement of Additional Information, as Amended May 7, 2007, Schwab changed the language in its Statement of Additional Information, again referenced in the Fund’s November 2006 Registration Statement, with respect to Concentration that
CONCENTRATION means that substantial amounts of assets are invested in a particular industry or group of industries. Concentration increases investment exposure. For purposes of a fund's concentration policy, a fund will determine the industry classification of asset-backed securities based upon the investment adviser's evaluation of the risks associated with an investment in the underlying assets. For example, asset-backed securities whose underlying assets share similar economic characteristics because, for example, they are funded (or supported) primarily from a single or similar source or revenue stream will be classified in the same industry sector. In contrast, asset-backed securities whose underlying assets represent a diverse mix of industries, business sectors and/or revenue streams will be classified into distinct industries based on their underlying credit and liquidity structures. A fund will limit its investments in each identified industry to less than 25% of its total assets.
The funds have determined that mortgage-backed securities issued by private lenders do not have risk characteristics that are correlated to any industry and, therefore, the funds have determined that mortgage-backed securities issued by private lenders are not part of any industry for purposes of the funds' concentration policies. This means that a fund may invest more than 25% of its total assets in privately-issued mortgage-backed securities, which may cause the fund to be more sensitive to adverse economic, business or political developments that affect privately-issued mortgage-backed securities.
Such developments may include changes in interest rates, state or federal legislation affecting residential mortgages and their issuers, and changes in the overall economy.
Statement of Additional Information, September 15, 2006, as Amended May 7, 2007.
Also, sometime in early 2007, Schwab removed CDs from the expense-ratio based compensation product group and into the individual stock product compensation group, for which Schwab brokers received less compensation. This move meant that CDs would pay a consultant only 4 basis points, whereas the Fund and other mutual funds would pay out 40 basis points. Thus, at the same time that Schwab was offering the Fund as a cash alternative investment, it provided its consultants with a greater financial incentive to promote YieldPlus over CDs.
As of May 31, 2007, the YieldPlus had grown to more than $13 billion. During this time, also again touting its Morningstar Rating, the Fund reported that it had outperformed the Lipper Ultra-short Bond Fund Category Average. In its Form N-Q, Schwab, for the first time reported that more than 45.1% of the YieldPlus Fund consisted of Mortgage Backed Securities, or approximately three times (3x) the amount of Mortgage Backed Securities owned just two years prior:
Holdings By Category Cost (000) Value (000)
45.1 % Corporate bonds $5,985,952 $5,993,310
10.9 % Asset Backed 1,444,182 1,442,119
46.5 % Mortgage Backed 6,203,156 6,177,217
1.1 % Preferred Securities 142,692 142,347
1.3 % Short Term 170,944 170,945
======= ========
Total Investments $13,946,926 $13,925,938
Schwab YieldPlus Form N-Q, May 31, 2007.
In its February 2007, Semiannual Report to its Shareholders, Schwab attempted to again downplay the YieldPlus’ exposures to Mortgage Backed Securities, and told its investors that “During the period, the fund increased its exposure to higher quality mortgage backed securities, while reducing its exposure to the sub-prime mortgage market.” (Ex. “S”)(emphasis added).
As of August 10, 2007, the per share price of the Schwab YieldPlus Fund decreased from $9.68 per share to $9.56 per share. On August 14, 2007, in its “Investment Management Perspectives” publication, Schwab, recognizing the increased risk and volatility all major fixed income sectors, as a result of the “sub-prime crisis,” assured its investors that the Fund does not own any Subprime Collaterialized Debt Obligations, and that the Fund “holds less than 5% of its total portfolio assets in subprime securities.” Again, touting the Fund’s out performance of the Lehman Brothers U.S. Treasury Short Term Index, Schwab urged that instead of focusing on the decrease in the share price of the YieldPlus Fund, “investors should be assessing an ultrashort bond fund based on its total return, which is a combination of the change in NAV (up or down) and the interest income. Id. at 4.
On August 17, 2007, Schwab posted a Investor “Q & A,” in its website by Randy Mark, the President and CEO of Charles Schwab Investment Management, entitled “amid Market Turmoil.” In this article, Mark, in response to a question as to what is changing bond values, explains that the “tumult has its roots in housing, specifically the crisis in the sub-prime mortgage market.”
In response to questions concerning the volatility of the YieldPlus fund, Mark again assures investors that the recent volatility of YieldPlus is not due to any “particular” bond issue, but rather “general market conditions,” affecting a number of funds of this type. According to Mark, “currently no ‘corporate’ bonds within the YieldPlus are in default, and the portfolio management team remains confident in the current positioning of the portfolio.” Id.
Of course, as set forth above, Mark fails to mention that from May 2005 through May 2007, the Schwab YieldPlus fund tripled its exposure to Mortgage Backed Securities, comprising more than 45% of the YieldPlus investment portfolio, and more than 90% of the Fund’s losses, as of May 31, 2007. Instead, in response to a question about “How concerned should I be about a drop on NAV in the Schwab YieldPlus Fund, Mark responds:
Investors should be assessing an ultrashort bond fund based upon its total return, which is a combination of the NAV (up or down) and the interest income. It’s important to remember that while the YieldPlus fund’s shares price (NAV) went down, the fund continued to generate income. Income is a much larger percentage of total return in the fund.
Id. at 3.
Similarly, on September 24, 2007, Schwab again posted on its website an article entitled “Volatility in the Fixed Income Markets and YieldPlus Fund Discussion,” featuring Kimon Daifotis, the Senior Vice President and Chief Investment Officer for the YieldPlus Fund. Daifotis, again attempting to blame any decrease in the value of the YieldPlus Fund on overall volatility in credit markets, admitted that the hardest hit bond sectors were “non-treasury fixed income securities, such as mortgage backed securities and assets backed bonds and corporate bonds.” Daifotis, again fails to mention that as of May 2007, according to the YieldPlus SEC Form N-Q, 45% of the YieldPlus investment portfolio was invested in Mortgage Backed Securities, which only two years earlier comprised approximately 15% of the YieldPlus portfolio, and which was responsible for approximately 90% of the YieldPlus realized and unrealized losses.
Instead, seeking to dissuade investors from selling their YieldPlus shares, Daifotis explains that the NAV of the YieldPlus Fund deceased by 26 cents, of which 22 cents was “unrealized.” In addition, Daifotis falsely assured investors with respect to the YieldPlus Fund that:
Since the funds inception in late 1999, if you look at rolling 12-month windows, the fund [has] been able to deliver competitive total return, which is a combination of monthly income and price return. My portfolio management team and I are committed to the investment strategy that outlined in the prospectus, so even through we’ve had recent market volatility, we remain steadfast and confident that we can execute on that strategy. Although there has been some price decline in our holdings over the course of the last few weeks, we remain confident that these are the right securities for our fund for the long term.
Id. at 2 (emphasis added).
Kimon Daifotis, in a letter dated January 29, 2008, finally acknowledged that the decline was due to “decreasing demand for certain mortgage backed securities,” but that “between June 29, 2007 and January 28, 2008, approximately 51 cents of the 71 cent per share decline in the NAV of the YieldPlus Fund represents “unrealized losses.” Daifotis, again attempting to minimize the funds exposure to Mortgage Backed Securities, now comprising almost half of the YieldPlus portfolio holdings, further adds that:
We have confidence in the structure and quality of the Fund’s holdings. Generally, we believe we can best serve our shareholders by holding the portfolio’s existing securities. This portfolio built over years, each bond carefully vetted and researched. The Fund’s SEC yield is just above 6% and the underlying holdings provide a steady stream to the Fund.
On April 1, 2008, the Retirement Income Fund redeemed its last remaining shares resulting in Schwab Funds no longer holding the Schwab YieldPlus Fund.
|
