Researcher says Oppenheimer Core Bond fund trouble obvious

As investors attempt to recover some of their losses in the Oppenheimer Core Bond fund — which was used by at least five 529 plans — one researcher is claiming they should have seen trouble coming long before the fund famously collapsed late last year.

According to a new analysis of the Oppenheimer bond fund debacle by Markov Processes International LLC of Summit, N.J., a returns-based style analysis would have alerted plan sponsors and investors that not only had the fund made a bad bet on commercial mortgage-backed securities, which tanked with the real estate market, but also it added even more risk by applying leverage to that bet.

Returns-based style analysis compares a portfolio's total returns to the total returns of benchmark indexes to see if the manager is drifting from the fund's investment style.

The Oppenheimer Core Bond fund lost 35.8% in 2008, compared with its benchmark index, the Barclays Capital Aggregate Bond index, which rose 5.3%.

Oregon's 529 plan sued OppenheimerFunds, a subsidiary of MassMutual Financial Group, Springfield, Mass., in April for understating the fund's risks and is looking to recover $36 million. Another five states — Illinois, Maine, Nebraska, New Mexico and Texas — are investigating whether Oppenheimer violated its fiduciary duty to investors in state-sponsored 529 college savings plans by failing to disclose its exposure to mortgage-linked securities. Last month, the Illinois treasurer's office announced a tentative agreement to recoup $77 million from OppenheimerFunds. All five states are in talks with the company, confirmed OppenheimerFunds spokeswoman Jeaneen Pisarra.

“We're involved in active discussions with all five states and are looking forward to potentially resolving the matter and moving on with our 529 business,” Ms. Pisarra said. Oregon is not involved in the talks, Ms. Pisarra said.

Michael Markov, CEO and director of research at Markov Processes International, said there were plenty of red flags at Oppenheimer Core Bond that these states and other investors could have picked up on. According to the firm's report, which was written by research analyst Daniel Li, investors first should have analyzed the fund's risk and return characteristics vs. its benchmark and its peer group benchmark of intermediate bond funds.

“You're really just trying to reconcile performance with the manager's stated style,” said Mr. Markov. “If they disagree, you have a problem.”

The firm's analysis found the Oppenheimer fund's returns were almost identical to its peer group from January 2005 through December 2007. The firm then ran a returns-based style analysis of the fund and compared it to a set of Merrill Lynch fixed-income indexes representing major fixed-income segments to determine a set of baseline factors.

Here, the researcher found the first red flag: Oppenheimer showed higher exposure to commercial mortgage-backed securities beginning in 2006, relative to the fund's historic average and peer group average.

Next, Markov analysts set out to monitor the fund's performance against its past style by creating a simulated portfolio, using the asset exposures as of Dec. 31, 2007. Returns from that portfolio were then compared with actual fund returns through Dec. 31, 2008. At the end of August 2008, fund exposures equaled 170% of net assets on a dollar basis, meaning $1.70 worth of shareholder capital was exposed to movements in a risky segment of the credit markets. It also showed implied leverage, meaning it could be a result of the fund holding fixed-income derivatives, such as total return and credit-default swaps, Mr. Markov explained.

“The fund was behaving as if it were borrowing cash, a typical derivative situation,” Mr. Markov explained. “You have added leverage. Now you have some questions for the manager. Returns-based style analysis doesn't so much give you an answer, as provides you with questions.”

Not everyone is convinced such analysis would have alerted Oppenheimer investors in time. “Its (returns-based style analysis) application is limited,” said Ted Disabato, managing director of investment consulting firm Disabato Advisers LLC, Chicago. “It's always easy to look back and find the warning signs.”

Clifford Stanton, chief investment officer at Prima Capital Holdings, Inc., an investment research and consulting firm in Denver, said that while his firm does use returns-based style analysis as part of its investment research, he finds the tool is best at detecting trends over time. “You need a fair amount of data to do this research well, and by the time you have enough data, the blowup has already occurred,” he said.

Mr. Markov counters that by using high-frequency data, such as daily or weekly returns, investors could see the risks well before a crisis. For example, using the Oppenheimer bond fund's daily return data from January 2005 through May 2008 to create a value-at-risk chart, shows the fund's daily risk nearly doubled in mid-2007 and continued to increase into 2008.

“The historical daily VaR exposed the problem, big time, months ahead of the blowup,” said Mr. Markov.