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Over the last several years, investors have earned slim returns for their short-term investments. Continuing turmoil in the financial marketplace has led the Federal Reserve Board to respond to each crisis by injecting liquidity into the system. This policy continually forces rates lower and makes it difficult for savers to earn much in the way of interest. In fact, current Treasury bill rates are at the lowest point in 50 years. Even banks are offering CD rates as low as 1 percent. With rates at a cyclical low, investors have been turning to less familiar investments in the hope of increasing the yield of their portfolios. Often, without realizing it, this reach for a little extra yield comes with a large amount of additional investment risk During the last six months, two popular, commonly thought of as safe, investments have had unforeseen consequences for investors. Investors searching for extra yield were surprised when both short-term bond funds and auction rate securities punished investors who were not fully prepared for their risks. While these occurrences are decidedly unpleasant, they once again remind us that risk and return are related. In a competitive marketplace, the only way that one investment can pay significantly higher yields than a competitor is by taking on significantly more underlying risk. First, let’s look at short-term bond funds. As an example, and just one of many, the Schwab YieldPlus Bond Fund is one that has fallen prey to the liquidity crisis. This fund was marketed as being somewhere between a money market fund and a short-term bond fund. The goal was for investors to earn a little bit of extra yield with just a little bit of extra risk. That extra risk, which appeared to be under control, caught most investors by surprise as this supposedly safe fund plummeted by almost 20 percent in the first three months of 2008. This fund, over the previous several years, has had good results for its category. In an environment of low yields, this fund had been outperforming the average fund in its category by a large margin. In 2005, while returning 3.35 percent for its investors, it outperformed the U.S. aggregate by .92 percent. In 2006, with a total return of 5.45 percent, it outperformed again by 1.1 percent. At one point it was in the top 15 percent of all the comparable funds in its category. These types of numbers attracted investors by the droves. Money poured into this fund and it continued to grow until it was one of the largest in the category. By June 2007 they were managing $13.5 billion of assets. Unfortunately, all of this additional return was accompanied by large amounts of additional risk. In the search for yield, the managers of this fund looked into riskier areas of the bond market. They invested in lower grade securities in their quest to earn market-beating returns. They believed that they had enough experience in analyzing corporate financial statements that their approach could yield additional return without additional risk. Even the reviewers over this period of time thought this fund was doing a pretty good job. In fact, one called it “a category killer.” But if investors had read through the literature they would have realized that this fund made extra return by taking on greater risks. They executed their strategy by investing in asset-backed and mortgage-backed securities that many other short-term bond funds shunned. If investors had spent as much time considering the risks of this fund rather than myopically looking at its returns, they would have moved more cautiously. Unfortunately, the perfect storm created by the recent credit crisis was devastating to this fund. As the fortunes of the companies they invested in experienced a rapid deterioration, so did the value of the fund’s investments. The dramatic loss in value caused investors to run for the doors. Now this fund manages only 5 percent of the assets it did a year ago. While the Schwab fund caused unpleasant surprises for its investors, it seems positively tame compared to how many people fared by investing in auction rate securities. Auction rate securities are usually municipal bonds, preferred stocks or similar debt instruments that have a unique way of resetting their interest rates. These instruments tend to have long maturities, but the current yield is reset through a monthly auction. Even though these are long-term securities, the relatively frequent auctions allowed them to be marketed to investors as short-term alternatives to cash. They worked pretty well for a while. Investors were attracted to their relatively high yields when compared to other cash alternatives and the belief that this was a liquid investment. This would work well as long as there were enough buyers to reset the price at each successive auction. If there were not enough buyers, the auction would fail and the investors from the previous auction would be left with their investment in these long-term securities. Few investors ever considered that a possibility. Investors assumed that there would always be a market for these securities. They believed that if there was a lack of demand at an auction, then the brokerage firm who brought them to market would bid for the oversupply with their own capital. Many brokers, in order to support their clients’ offerings, did this several times on previous occasions, but it was not contractual. Unfortunately, in the midst of this year’s credit crunch, most of the major brokerage firms had no excess capital to use to support these markets. When the auctions failed to attract enough new buyers, the brokerage firms declined to bid as well. Investors who believed they had a relatively safe short-term cash alternative soon found out that they may be invested in these funds for years. Unlike poorly performing mutual funds, where you can sell if you are willing to take a large loss, there is no ready market for these auction rate securities. Investors who placed funds in these securities cannot get their money out until the market stabilizes. This has led to the filing of class action lawsuits and investigations by several state securities regulators. The New York law firm Seeger Weiss has filed several class-action lawsuits against major New York brokerage firms alleging that the risk of holding the securities was misrepresented to investors. In the long run, if investors can prove misrepresentation, they might be made whole by their lawsuits, but they might have to hold these positions for years. What could they have done differently to prevent this from happening in the first place? They should have paid more careful attention to why these funds were offering such high yields. When you are presented with an opportunity that offers higher returns than comparable market returns you should first ask yourself: What’s the catch? Investors receive higher yields for taking higher risks. That is a fundamental concept of investment theory. This is what you can do to prevent this from happening to you in the future. If an offered yield seems suspiciously high, investigate further. Try to find out what additional risks you need to bear in order to obtain this additional return. This can usually be obtained from a disclosure statement, or additional conversation with an adviser. If this information is hard to come by, or if you are unable to receive a satisfactory explanation from whoever is advising you, you need to pass on the opportunity. If an investment is so complex that it is difficult to get a clear understanding of the possible payoffs, it should probably more properly be classified as a speculation. Speculations are not appropriate for short-term investors. If you need short-term, readily marketable obligations for safety, make sure that the underlying investments are safe. The easiest way to do this is to stay in traditional, safe investments and avoid anything with twists or complexities. If your goal is to have a pool of safe assets on hand, stay with ones that are easily recognizable. Short-term Treasury bills, short certificates of deposit and high-grade government money market funds all filled this particular niche very well. In an environment of very low interest rates, it is always tempting to earn extra yield by investing in securities you don’t quite understand. If the opportunity seems too good to be true, it probably is. WILLIAM Z. SUPLEE IV is the president of Structured Asset Management Inc. in Paoli, Pa., and an adjunct professor of investments at the American College in Bryn Mawr, Pa. Hemay be reached at 610-648-0700 or [email protected].

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