Fair Game: Willow Fund as a Cautionary Tale for Investors

With a portfolio that specialized in distressed debt instruments, the Willow Fund had suffered losses of almost 80 percent in the first three quarters of 2012 after its longtime manager switched gears: he had abandoned the corporate debt markets he was familiar with and piled into some colossally bad derivatives trades. The investors, some of whom hadn’t realized they were holding a portfolio filled with risky bets against the debt of European nations, were stunned.

What happened to the Willow Fund is a cautionary tale for any investor who entrusts his or her money to an investment fund. Its demise highlights the dangers when a portfolio manager makes a big change in investment strategy. It also raises questions about how assiduously this fund’s independent directors watched over the manager as he ramped up his portfolio’s risk levels. Both are problems that investors cannot be complacent about.

Ken Boudreau, 70, of Farmington, Conn., is an aggrieved Willow Fund investor who has filed an arbitration case against UBS to recover his losses. Mr. Boudreau began putting money into the fund in mid-2009, investing a total of $350,000. His losses were $300,000.

In an interview, Mr. Boudreau said his UBS brokers had contended that the fund’s investment in distressed debt securities positioned it well for gains in 2009 as the economy recovered from the credit crisis. The experience and track record of Sam S. Kim, the portfolio manager overseeing Willow since it began operations in 2000, was another selling point. Mr. Kim was expert at analyzing distressed debt instruments, Mr. Boudreau said his brokers told him.

“I try to be a disciplined buyer and seller, buying in when markets are down,” Mr. Boudreau said in an interview. “In mid-2009, distressed debt seemed to me a home run.”

Which it might have been, had Mr. Kim, the money manager, not plunged headlong into credit default swaps on government debt of Germany, Sweden, France, Spain and other nations. In these trades, Mr. Kim was buying a type of insurance against the nations’ defaulting; his investors, therefore, would benefit if problems in these nations worsened.

According to regulatory filings, the Willow Fund had an impressive run through 2006. That year, the fund returned almost 25 percent on a portfolio of corporate bonds, bank loans and corporate repurchase agreements, a financing arrangement. Credit default swaps amounted to a minuscule 0.18 percent of the Willow Fund in 2006.

That portfolio was consistent with the fund’s description in regulatory filings. It would “maximize total return with low volatility by making investments in distressed investments,” the filings said, “primarily in debt securities and other obligations and to a lesser extent equity securities of U.S. companies that are experiencing significant financial or business difficulties.” The fund might also hedge its portfolio against risks, using credit default swaps, the filings said, or use those instruments “for non-hedging purposes.”

In 2007, the Willow Fund’s exposure to credit default swaps started rocketing. That year, Willow also began generating losses — 9.1 percent, and then 18 percent in 2008 when the credit crisis hit.

As Mr. Kim’s view soured on world economies, particularly in the euro zone, he began trading on these concerns, a letter from UBS to investors said. That meant more of the portfolio went into credit default swaps.

By the end of 2008, corporate bonds amounted to only 6 percent of the portfolio, down from 29 percent a year earlier. The value of the credit default swaps, meanwhile, had ballooned to 25 percent of the portfolio from 2.6 percent in 2007. By 2009, when Mr. Boudreau began investing, credit default swaps amounted to 43 percent of Willow’s portfolio, a fact that Mr. Boudreau said he did not know.

THE fund’s disclosures that it might invest in credit default swaps gave insufficient warning to investors of the risks in these strategies, said Jacob H. Zamansky, a lawyer who represents Mr. Boudreau and other investors in the Willow Fund.

Mr. Zamansky pointed to Securities and Exchange Commission guidance in 2010 telling mutual fund managers in general to be specific about strategies involving derivatives. The S.E.C. was concerned that some funds were making generic disclosures about derivatives that “may be of limited usefulness to investors in evaluating the anticipated investment operations of the fund, including how the investment adviser actually intends to manage the fund’s portfolio and the consequent risks.”

Article source: http://www.nytimes.com/2013/03/31/business/willow-fund-as-a-cautionary-tale-for-investors.html?partner=rss&emc=rss