Failed Fund Is ‘Exhibit A’ in Levitt Testimony on Derivatives

Securities and Exchange Commission Chairman Arthur Levitt Jr. went to Capitol Hill on Tuesday to talk about risk in the mutual fund industry, and he brought some startling news to underscore his point: the first outright failure of a money market fund.

The SEC announced that the Denver-based Community Bankers U.S. Government Money Market fund will liquidate because of losses caused by so-called derivative securities.

The fund’s 90-some shareholders--all institutional clients--will get back 94 cents for each $1 they invested.

For the $2-trillion mutual fund industry, the demise of the Denver fund is both a black eye and a blessing. Until now, investors had never lost a penny in a money fund, a fact that has allowed these funds to develop an unwarranted reputation for complete safety since 1974.

But if a money fund were going to fail, the industry couldn’t ask for a better victim. The Denver fund’s assets were only $82 million, and no small investors were in it. So the SEC can use the isolated incident of this fund’s collapse to force all investors to sit up and take notice, without risk of inciting a public “run” on money funds.

For Levitt, the Denver fund’s failure because of derivative-securities losses provided the perfect backdrop for his testimony before a House subcommittee. His message: The fund industry’s painful experience this year with exotic securities such as derivatives highlights the need for a standard way of measuring and disclosing fund risk--so that shareholders (and perhaps regulators) aren’t blindsided.

Derivatives, which are hybrid, often “synthetic” securities created by Wall Street, have been used by mutual funds for years. They can be as simple as futures or options contracts, or vastly more complex. They can be used to speculate on market moves--taking fund investors way out on the risk curve--or, conversely, they can be used to hedge a portfolio, thereby reducing the fund’s risk.

This year, many money market funds and bond funds were hit by surprise losses when derivative securities they had purchased went awry, mostly because interest rates have risen faster than most Wall Streeters expected. Some of the losing funds--including, until now, all of the money funds--bailed out shareholders by going to their parent companies for cash infusions to cover losses.

But those costly bailouts haven’t lessened the concern on Capitol Hill that the fund industry has been playing haphazardly with shareholders’ money in high-risk derivatives, while shareholders may have blithely assumed that all they owned was plain-vanilla stocks or bonds.

Responding to congressional pressure, the SEC has proposed cutting the maximum a fund can invest in “illiquid” securities, including most derivatives, from the current 15% of assets to 10%.

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More important for most fund shareholders, however, would be better disclosure of derivative investments and their uses in funds--because the simple fact is, these hybrid issues aren’t going away, and neither should they.

“The problem isn’t the securities,” says James Midanek, a derivatives authority at Solon Asset Management in Walnut Creek, Calif. “The problem is people bought things they didn’t understand.”

But can derivative risk, and mutual fund risk generally, be standardized in some way that is accurate and easy for most fund investors to understand in fund literature? One early proposal was that funds merely disclose the percentage of their assets in derivatives. Yet some fund industry executives say that would barely be useful.

Stephen Gibson, managing director of retail marketing at Putnam Funds in Boston, notes that “it doesn’t take a lot of poorly structured derivatives to create considerable risk in a fund.” So a low percentage of derivatives, depending on their type, might wrongly suggest to shareholders that there is little risk of loss from the securities.

The SEC, and the Investment Company Institute (the funds’ trade group), now seem to be leaning in another direction: Requiring of each fund standardized, plain-English disclosure of such common risk barometers as “beta” (a measure of volatility) and, for income-oriented funds, “duration,” which measures how a fund’s principal changes with rising or falling interest rates.

Whether those yardsticks of risk could then be combined into something far more simple in fund literature--say, a numerical scale by which funds would identify their risk level as somewhere between one and 10--is far from clear. Such a system may sound ideal, but it may also be so simplistic as to be misleading, fund experts say.

Standard & Poor’s, the credit-rating agency, this year began providing ratings of bond and money fund risk for funds willing to pay for them. Research firm Morningstar Inc. already calculates fund betas and other such barometers for its subscribers. But the ICI understandably argues that the industry should standardize something that can be done in-house by each fund.

The SEC will seek public opinion on risk disclosure ideas early in 1995. But analysts say that, no matter what new format for disclosure emerges, the best way for investors to avoid dicey funds is to follow one rule: If a fund’s return is above-average, it’s probably taking above-average risk. If you’re not an above-average risk-taker, avoid funds that shoot for the moon.

S&P;’s Fund Rating System

In an attempt to help bond mutual fund investors better understand the relative risk in their funds, Standard & Poor’s Corp. has developed a rating system similar to its bond credit rating system. How S&P; characterizes funds:

Rating / Bond fund description:

AAA: Extremely low sensitivity to changing market conditions and offers greatest stability of returns

AA: Low sensitivity to changing market conditions and offers stable returns over short and intermediate horizons

A: Sensitive to changing market conditions and offers stable returns over intermediate and long horizons

BBB: More sensitive to changing market conditions and will have greater variability of returns, but have adequate stability over long horizons

BB: Very sensitive to changing market conditions, so returns can be volatile, especially over short or intermediate horizons

B: Extremely sensitive to changing market conditions, and may possess speculative characteristics, with returns highly volatile over all holding periods

Source: Standard & Poor’s Corp. * NEW RULES

Regulators take steps to prevent conflicts of interest in financial advice. D3