Your Post-Subprime Portfolio

Following expert advice hasn't helped many investors. Here's what went wrong, and what you need to do now

by Aaron Pressman

Browse Issues

Browse the BusinessWeek Archive

Story Tools

• post a comment
• e-mail this story
• print this story
• order a reprint
• suggest a story
• digg this
• save to del.icio.us

Alison Seiffer

Saving for retirement has never been easy, but the past year has made a complicated task all but overwhelming. The ongoing collapse of the credit markets, sparked initially by problems in subprime mortgages, has challenged some of investors' most cherished and reliable investment beliefs and strategies. Auction-rate securities sold as "cash equivalents" ended up sticking investors with huge losses, supposedly low-risk bond funds blew up, and for those who thought they'd pay for retirement by selling the house—well, need we say more?

As all manner of underappreciated and ignored risks have come back to haunt those who followed the generic advice of brokers, financial advisers, and fund salespeople, let's look at what happened and how to avoid future portfolio potholes.

BOND FUNDS AREN'T THE SAME AS BONDS

Government bonds provide investors with predictable cash flow and the comfort that principal will, barring catastrophe, be repaid at maturity. Bond funds, however, are different, as some investors found out to their horror when the subprime mortgage market plummeted. Mutual funds run by Fidelity and Charles Schwab (SCHW) and promoted as low-risk, ultra-short-term bond funds got caught dabbling in subprime securities. Fidelity's ultra-short fund lost 13% over the past year, and Schwab's YieldPlus Fund (SWYPX) fell a jaw-dropping 32%.

Many advisers think it's smarter to own individual government bonds. That avoids management fees that erode already slender returns. "You're paying an awful lot for the simplicity of the experience," says Richard Kang, a risk-and-investing consultant for institutional investors. He suggests investors buy bonds of various maturities directly to create what's known as a laddered portfolio.

Studies of bond fund performance find the products rarely best the index they're designed to follow. Over the past 10 years bond funds didn't even top the simple strategy of buying a 10-year U.S. Treasury note, which sold in May 1998 with an annual yield of 5.65%. Individuals who bought actual bonds slept soundly, safe in the knowledge that they'll get back their full principal when the bonds mature. The bond market subsequently went on a wild ride, crashing in 2000, rallying in 2004, and then gyrating out of control over the past two years.

As a result, investors in bond funds have had anything but the peaceful experience that bond buyers have enjoyed. The average annual return of intermediate government bond funds over the past 10 years was 4.75%; only 7 out of 223 funds tracked by Morningstar (MORN) in that category since 1998 beat the Treasury return of 5.65%—even with all interest payments reinvested in the funds. A bond buyer who also reinvested all interest payments in a money-market fund would have made even more than the Treasury yield.

"CASH EQUIVALENT" ISN'T NEARLY THE SAME AS CASH

Investors looking for low-risk, stable vehicles in which to invest their cash savings typically relied on certificates of deposit and money-market mutual funds. Both are heavily government regulated, and both suffered from historically low yields over the past few years. So banks and brokerage firms started pushing an alternative dreamed up on Wall Street, dubbed auction-rate securities. These securities, which carried AAA ratings, were actually long-term bonds or shares of preferred stocks. Investors were supposed to be able to sell at auctions every 7, 28, or 35 days. But few were told what would happen if no new buyers showed up at the auction: They'd be stuck.

Harry Newton, 66, sold his telecom industry publishing business a few years ago and ended up with $3.5 million stuck in auction-rate securities pitched as cash equivalents, he says. The yield was slightly higher than on money- market funds, so he'd invested. But in February the market seized up, trapping Newton's money.