A Catastrophe To Learn From

Here's a wild one by way of Bloomberg about the following high yield muni bond fund.

It holds/held mostly unrated bonds that don't trade, there really is no market for them. They are valued using pricing services that try to compare versus similar bonds. This is not uncommon but the pricing isn't necessarily accurate. The fund was carrying a couple of issues at 70-80 cents on the dollar that were more correctly valued at less than five cents. 

The fund faced heavy redemptions as part of the fallout from the April crash which cascaded into a series of unfortunate circumstances eventually leading to what looks like a permanent impairment of capital. 

Part of Bloomberg's coverage included an investor whose advisor put him into the fund leading to an arbitration filing. I asked Copilot to find the arbitration filing to see what percentage of the the investor's account was in the fund and while a percentage was not available, Copilot's conclusion from the filing was that it had to have been a large percentage. 

It was already a one star fund for poor risk adjusted returns before this happened, also according to Copilot.

If ever there was the perfect anecdote for diversifying your diversifiers, this is it. Over a long enough period, the odds of owning one or two things that blow up like this is pretty high. It may be unavoidable but the impact of such a blow up can be pretty easily mitigated with correct position sizing.

Per Bloomberg, RJMAX was yielding 300 basis points or so above high quality muni's. Whether that spread was a enough compensation is a different discussion but even if it was enough compensation, 300 or more basis points tells you it is risky. The way I size some of the esoteric fixed income segments is pretty small. If a client is 60/40 then I might go with 8-10% of the fixed income sleeve or 3.2%-4% of the overall portfolio. A 65% drop in a 4% weighted bond fund would be a 260 basis point hit to the portfolio. That is not a ruinous hit to the client's portfolio. 

Somewhere on an advisor's priority list (very high up) should be making sure clients aren't financially damaged by what you do. Let's be clear though, if the S&P 500 drops 50% and the equity allocation in a portfolio drops 55% that is not what I mean. A long time ago, a reader shared that he had 25% of his portfolio in a lottery ticket biotech that I believe was working on something for migraines. The stock blew up. It was his own doing but an advisor doing something like that is what I mean. Without knowing, if the advisor in the RJMAX story had 10% of the client's total portfolio, I don't think even that would rise to the level of ruinous but that is far more than I would ever do. A 20% weighting to something with the idiosyncratic risk of RJMAX would probably cross the line. 

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