The Decade's 10 Worst Fund Disasters

Even in a decade that has been defined by disasters, these 10 stand out.

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When the dot-com bubble burst in early 2000, most investors thought the mutual fund industry couldn't sink any lower. Ten years and two recessions later, it now appears that they slightly misjudged the situation. In fact, for fund investors, this decade has been defined by a seemingly unending stream of blunders and disasters. Here are 10 of the worst:

[Slide Show: The Decade's 10 Worst Mutual Fund Disasters.]

The Reserve Primary Fund. On September 16, 2008, the iconic Reserve Primary Fund's price dipped below $1 per share, shattering the notion that money market funds couldn't lose money. As investors dashed to cash in their shares, the fund had to put a freeze on redemptions. Meanwhile, the panic quickly spread throughout the entire money market sector, and funds suddenly found themselves struggling to stay afloat. On September 19, the federal government announced a plan to temporarily insure money market funds, and only then did investor confidence begin to rebound. Ultimately, the Reserve Primary Fund's biggest blunder was putting too much faith in Lehman Brothers. When Lehman went under, the fund was left hanging on to $785 million in suddenly worthless bonds. Jeff Tjornehoj, Lipper's research manager for the United States and Canada, calls the fund's entanglement with Lehman Brothers an example of managers "trusting their instincts over their investing discipline." Even today, the Reserve Primary Fund debacle continues to mar the money market sector's reputation, and drawn-out courtroom proceedings during which investors angle to recover their losses have done little to reduce the incident's high-profile nature. On the bright side, investors are expected to eventually recover 99 cents on the dollar.

[See SEC Looks to Put Buck Back Together in Money Market Case.]

The market timing scandal. This scandal, which blew up in 2003, proved to be tremendously scarring for the fund industry, largely because it was so widespread. Some of the biggest culprits included Janus, PBHG, Bank of America, and Putnam, but after the smoke cleared, it seemed as though almost the entire industry had been implicated in one way or another. Funds faced a whole host of charges, including allegations that they were involved in front running (tipping off favored investors before making trades) and illegal late trading. "It emerged that a lot of nasty practices were going on," says Russel Kinnel, Morningstar's director of mutual fund research. Since funds engaged in these practices on behalf of their most influential clients, the scandal was a slap in the face to ordinary retail investors, and it undermined their confidence in the industry charged with securing their retirement savings. At the same time, the scandal proved that even though mutual funds are heavily regulated by the government, there are still plenty of outlets for shady activities. To this day, the scandal continues to haunt the fund industry.

The Merrill Lynch Internet Strategies Fund. Now that 10 years have passed, it seems somewhat frivolous to scold funds that failed to see the dot-com bubble coming from a mile away. Merrill Lynch, on the other hand, got within inches and still didn't sense the implosion, and for that it makes this list. In March 2000, the same month that the bubble burst, Merrill Lynch launched its Internet Strategies Fund. Talk about dismal timing. "People thought that somehow the Internet boom was going to go on forever," says Kinnel. The Internet Strategies Fund lasted for just over a year, and during that time it lost a staggering 70 percent. While Internet Strategies had what was perhaps the industry's most embarrassing timing, it was hardly the only fund to close its doors in the wake of the bubble. "Funds went overboard, and the shareholders had to pay big time," says Dan Calabria, a former president and CEO of Templeton Funds and author of Mutual Funds Today: Who's Watching Your Money? "That kind of excess is something that we have to be very, very careful about."

The Chicken Little Growth Fund. Before even getting to performance, we take issue with this fund's unfortunate name. After all, what investors would want to entrust their savings to a fund named after a psychotic (albeit cute and inexplicably sentient) chicken who constantly rants about the world's impending doom? More important, though, despite its charge to put together a portfolio for investors who were afraid of the market, this fund made big bets on a small number of stocks. For a while, this concentrated strategy paid off. But in 2007, just 16 months after the fund's launch, the sky did indeed come crashing down, claiming Chicken Little Growth as its sole victim. The fund went under amidst terrible performance and allegations that management had defrauded investors. In the "awful name" category, an honorable mention goes to the Ancora Homeland Security Fund, which was liquidated in 2008. As was the case with Chicken Little Growth, a gimmicky name was about all this fund had to stand on. Still, we suspect that investors have a slightly harder time falling asleep at night now that their fund company is no longer in the business of fighting the war on terrorism.

[See the 10 Strangest Mutual Funds.]

Congressional inaction. While mutual fund managers deserve most of the credit for their industry's deteriorating reputation, there's plenty of blame to go around—and lawmakers have certainly earned their portion of it. For starters, they've consistently overlooked the Generate Retirement Ownership Through Long-Term Holding, or GROWTH, Act, which has been languishing in congressional committees for almost the entire decade. Currently, when a mutual fund sells a holding at a profit, investors are required to pay annual taxes—usually at a rate of 15 percent—even if they put the money back into the fund. Critics have blasted this taxation as unfair, and this bill looks to encourage long-term investments by applying the tax only after shareholders withdraw their money. Among other setbacks, Congress has failed to push through the Arbitration Fairness Act, which would ban the mandatory arbitration clauses that have long left investors without adequate legal recourse against their funds. "There have been some obvious deficiencies in mutual fund regulation that Congress has left unaddressed, and shareholders are paying the price," says Mercer Bullard, a professor at the University of Mississippi School of Law and the founder of the shareholder advocacy group Fund Democracy.

[See Mutual Fund Bill Remains in Congressional Limbo.]

Schwab YieldPlus. The theory behind ultrashort bond funds is astonishingly simple: Given the short durations of their holdings—six months is the average maturity—the funds should not lose much value even in tough times. Schwab, however, managed to pull off the seemingly impossible when YieldPlus lost an astounding 35.4 percent in 2008. The average ultrashort fund, meanwhile, lost just 7.9 percent that year. Unlike many of its peers, YieldPlus had heavy exposure to risky mortgage-backed securities that imploded during the downturn. "Schwab YieldPlus is one of the all-time great fund debacles," says Kinnel. "It was an ultrashort bond fund that they were pushing as an alternative to a money market fund. ... People expected that if it was going to lose any money, it was going to lose half of 1 percent or something."

TCW ousts Jeffrey Gundlach. Just try to follow the flawless logic here: Concerned that star manager Jeffrey Gundlach would leave and take a large portion of his staff with him, TCW in December 2009 fired Gundlach … thereby guaranteeing that he'd leave and all but guaranteeing that he'd take a large portion of his staff with him. So far, the results have been disastrous for TCW. At least 40 employees have followed Gundlach out the door, and TCW's flagship Total Return Bond Fund has seen billions in outflows. Apart from Gundlach, notable departures have included Ron Redell, who headed TCW's mutual funds arm, and Philip Baruch, who comanaged the Total Return Bond Fund. Both have joined Gundlach in his new venture, DoubleLine, a money management firm that is certain to draw plenty of business from TCW. It will most likely be successful in poaching clients from TCW because investors often form much closer attachments to individuals than they do to institutions, and in TCW's case, Gundlach and his team had been a tremendous draw. TCW obviously knows this—otherwise it wouldn't have fired Gundlach in hopes of limiting the staff exodus. But in doing so, it turned a potential disaster into a guaranteed one. So much for strategy.

Direxion Monthly Emerging Markets Bear 2x. This fund's description reads like a veritable checklist for a disastrous investment: It is highly leveraged, it focuses on emerging markets, and it is subject to significant tracking errors unless you buy and sell it at precisely the right times. With that set of ingredients, it's no surprise that the fund has lost an average of 58 percent over each of the past three years. The fund's main directive is to use leverage to achieve monthly results that are equal to two times the inverse of its benchmark, which is the MSCI Emerging Markets Index. When the index goes up, the fund should go down, and vice versa. What's stunning, then, is that the fund managed to lose nearly 23 percent in 2008 even as its index shed 53 percent. In many ways, though, this fund is merely a symptom of the much larger problem of highly leveraged funds. In theory, they can be a useful way for professional investors with laserlike insight into the market to make short-term bets on indexes, but their continued popularity suggests that people are already forgetting the lessons that the recession should have deeply ingrained into their psyches. Even if these funds do manage to hit a smooth patch, there's no telling when they'll blow up again. "It's another form of IED," says Calabria. "They're investment explosive devices."

The Morgan Keegan RMK funds. Horace Grant was hardly alone when he discovered how painful it is to be a Bull in a bear market. The former basketball star, best known for his career with the Chicago Bulls, was among the Morgan Keegan & Co. shareholders whose investments took an unexpected dive during the credit crisis. But earlier this year, Grant netted a victory: He won $1.46 million from Morgan Keegan after charging that the company underplayed the amount of risk that some of its bond holdings carried. Like Schwab YieldPlus, Morgan Keegan's RMK bond funds got tied up in mortgages and paid the price during the downturn. In the year starting March 31, 2007, the RMK funds lost $2 billion. Since then, Morgan Keegan has been swimming in arbitration filings from investors who, like Grant, are crying foul. While Morgan Keegan is among the most extreme examples of fund blowups, other companies have also been bombarded with arbitration claims. Through November, the Financial Industry Regulatory Authority had received 1,479 arbitration filings involving mutual funds. That's 38 percent more than it saw in all of 2008.

Janus. Janus Capital Group's logo, which features a two-headed figure with one head looking forward and the other backward, is a reference to the Roman god after which the company is named. Considering the performance of Janus's mutual funds over the past 10 years, the image seems particularly fitting. That's because even as Janus gazes into the future, it does so with at least one eye trained on the past and the mistakes that nearly crippled the company. In the early 2000s, Janus found itself paralyzed by the dot-com bust. Its Global Technology Fund, for example, lost 84 percent during the 2000–2002 bear market. Meanwhile, Janus also suffered substantially from its hefty exposure to Enron, which was among the top 10 holdings in some of its funds. As of September 2001, just a few months before Enron went under, Janus's funds held 41 million of the company's shares. Notably, this Enron exposure destroyed Janus's reputation for thorough research and talented stock pickers. Just a couple of years later, Janus was implicated in the 2003 market timing scandal. Facing allegations that it let its favored clients profit at the expense of retail investors, Janus settled the next year for $226 million. In other words, as far as miserable starts to the decade go, Janus tops the list. To its credit, though, Janus appears to have learned from its mistakes and is now back on its feet.