YieldPlus fallout darkens advisors' view of Schwab as asset manager

Financial advisors whose clients’ assets plummeted in Charles Schwab & Co. Inc’s catastrophic YieldPlus fund were relieved to hear that the company is paying out $119 million at the behest of regulators, mostly to investors who lost money.

But, while advisors still trust Schwab as their custodian, this case — and the fraud complaint the SEC filed against two Schwab executives — makes them think twice about using the company’s fund managers, some said.

“I remember sitting in on their conference calls when the fund was eroding and they repeatedly kept saying that things would be OK,” said Financial advisor Penny Marlin, of Delray Beach, Fla.,-based Marlin Financial. “A lot of people got burned. I had a lot of sleepless nights back then.”

Marlin said her clients each individually lost thousands from YieldPlus. She also invested personally in the fund. She custodies all of her assets with Schwab Advisor Services and is happy with them as a custodian but will scrutinize their funds more closely.

Schwab is paying the $119 million to settle charges with the U.S. Securities and Exchange Commission, FINRA and Illinois regulators. All three groups determined that the company marketed the fund as a safe alternative to cash when in reality the fund’s investments were far riskier.

The YieldPlus Fund is an ultra-short bond that at its peak had $13.5 billion in assets and more than 200,000 accounts. Its assets fell from $13.5 billion to $1.8 billion during an eight-month period. The fund had more than 25% invested in mortgage-backed securities.

Reducing impact of credit crisis

In its statement, Schwab said the company worked closely with regulators to craft the resolution. Schwab said it would never seek to profit at the expense of its clients. The company did not admit any wrongdoing. “We are pleased that the bulk of associated payments will go directly to YieldPlus shareholders further reducing the impact of the credit crisis on them,” the company said.

Charles R. Schwab, company founder and chairman, was one of the largest investors in the fund, the company noted.

Rob Siegmann, a Cincinnati-based advisor with Financial Management Group Inc., which manages about $195 million, said the case cemented his view that Schwab is “an excellent custodian, but a terrible asset manager.”

Siegmann said that, luckily, his firm sold YieldPlus early on, but said clients still lost money.

“Schwab was reaching for yield by buying these packaged securities and they got left holding the bag,” he said. “They messed up. At least our clients will get a little back but not very much.”

Executives accused

The SEC is alleging that Schwab executive Kimon Daifotis, the former chief investment officer for fixed income, and Randall Merk, an executive vice president at Schwab, committed fraud and other securities law violations in connection with the offer, sale and management of the fund.

In fact, in statements regulators said that Daifotis knew that YieldPlus had experienced more than $1.2 billion in redemptions during the two weeks prior to the conference calls, which caused YieldPlus to sell more than $2.1 billion of its securities.

Meanwhile, Merk also wrote, reviewed and approved misleading statements about the fund such had a false claim that the fund had a “short maturity structure” that “mitigated much of the price erosion” experienced by its peers.

Pat Huddleston, president of Investors Watchdog, said this case is a reminder to investors and advisors as well to scrutinize all funds closely and carefully. See “

“For RIAs, you have to be appropriately skeptical,” he said. “Sometimes, it doesn’t seem that’s even possible that the marketing materials can be true and at the same time the prospectus is true. It’s an awful lot of work.”

Nipped by the market

Some advisors also feel Schwab still got off pretty easily with the fees.

“It seems like a pretty small amount,” said advisor Norm Boone, with Mosaic Financial Partners Inc., whose firm manages about $400 million in San Francisco. “I’d guess this isn’t going to do more than cover attorneys’ fees.”

Boone said there’s one advisor on his staff who has some concerns about using Schwab funds, but overall he said he and the rest of the advisors feel confident in the company’s money management skills.

“Our position is this was a unique situation,” he said. “The investment managers themselves were very clear to us what they were doing and they didn’t mislead us. But the market nipped them.”

The SEC said the payments will be placed in a Fair Fund for distribution to harmed investors and the related recoveries by other regulators such as FINRA may be contributed to the Fair Fund as well. The U.S. District Court for the Northern District of California will need to approve any payments.