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The collapse of the Oppenheimer Core Bond fund had many scratching their heads as to how this could have happened. The past two decades have seen bond funds in seemingly safe categories lose hundreds of millions of dollars. Fortunately for investors, there are tools and techniques available to provide early warning signs that can help avert a potential disaster.

The OCB fund, invested heavily in credit and mortgage-backed securities, lost 35 percent in 2008 and an additional 10 percent in the first three months of 2009. The risks were further multiplied because of the extensive use of derivatives such as total-return and credit-default swaps. The case has received enormous attention in part because the popularity of the OCB fund with 529 state plans resulted in significant losses to thousands of individual college savings accounts. Even as class-action suits were filed, the central question remains: What lessons can be learned from this fund’s collapse?

It’s not the first time an institutional bond fund lost a significant amount of value because of massive leveraged bets on mortgage-backed securities. The Piper Government Income Fund lost over 30 percent within several months of 1994. From its inception in 1988 through early 1994, the fund was consistently one of the top performers in its category. Such performance results didn’t come without risk, however, as the fund management team steadily moved the entire portfolio into collateralized mortgage obligations and other exotic derivatives. By 1994 the fund’s leverage had reached 50 percent, in an attempt to magnify performance. Rising interest rates and the CMO market collapse in April 1994 eventually led to the fund’s downfall.

Similarly, the OCB fund managers are blamed for taking excessive risks that eventually led to significant losses. Research analysts are claiming that the fund’s reports did not indicate the levels of risk and leverage that would later be brought to light. It is apparent, however, that plenty of red flags were raised for investors. First, the fund’s managers were vocal about the risks they were taking and even stated their allegiance to commercial mortgage-backed securities in the pages of The Wall Street Journal months before the fund’s collapse. Plus, the fund’s Securities and Exchange Commission filings for years showed investment in anything but safe government securities. Although some may argue that there is a significant delay in receiving the most recent fund positions, a crucial piece of fund information is delivered and available to the public daily — the fund’s net asset values.

Mutual fund NAVs, which are published daily in major newspapers and can be downloaded for free from Yahoo!, MSN and Google, are not only useful in monitoring one’s 401(k) portfolio, they contain a wealth of information about the inner workings of a fund. This concept was first advocated by Nobel laureate William Sharpe. In a series of papers in 1988–’92, he developed an approach now known as returns-based style analysis or “due diligence by replication.” The gist of this methodology, which has become ubiquitous in the analytic arsenal of both research analysts and investors, is that a fund’s return can be replicated by a basket of generic market indexes given scant information about the fund’s investment strategy. The resulting replication portfolio can provide insight into the manager’s strategy, style drift, selection skill and leverage — and even alert to potential fraud.

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