By Ben Eisen, MarketWatch
NEW YORK (MarketWatch) — The Oppenheimer Rochester group of municipal bond funds has more than a sixth of its assets under management tied up in the struggling commonwealth of Puerto Rico, a bet that made it a star when the island’s bonds were in high demand, but that recently led to losses, outflows, and regulatory scrutiny.
Rochester, a division of OppenheimerFunds, which is owned by Massachusetts Mutual Life Insurance Company, has the most concentrated exposure to the now junk-rated island’s debt among all U.S. mutual funds, according to Morningstar data. That helped spur double-digit returns in many of its 20 municipal bond funds as recently as 2012, but was the main factor in double-digit losses in many of those same funds last year.
Rochester, a big player in the muni market, is one of a handful of fund families attempting to outperform peers by betting on unloved securities that pay well because others shun them as too risky or volatile, according to fund analysts. The research-intensive investing strategy was pioneered by Ron Fielding, a former veteran of the firm, who likens his money management methodology to the value-investing philosophy of Warren Buffett. A spokesperson for Rochester declined requests to comment for this story.
Such a contrarian strategy can look even more attractive when rates drop, as they did when the Federal Reserve’s five-year policy of near-zero interest rates sent bond yields to record lows.
Bond buyers sought Puerto Rico’s higher yields and triple tax exemption — from federal, state and local taxes — in exchange for the risk the commonwealth could default on its debt due to persistent struggles with budget deficits, a flagging economy, and tight liquidity conditions.
A lot of muni funds own Puerto Rico debt. But Rochester took the Puerto Rico bet to greater extremes than any other U.S. mutual fund group. Across its funds, Rochester has $4.6 billion, or 17%, of its $26.9 billion in assets invested in Puerto Rico bonds, making the percentage of its total holdings invested in the commonwealth the largest among U.S. municipal bond fund complexes by a factor of two, according to Morningstar data, which uses data from January.
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Placing a large and concentrated bet on an undervalued security is nothing new for mutual funds. Others that have taken focused bets into select securities include Bruce Berkowitz’s Fairholme Fund /zigman2/quotes/200889155/realtime FAIRX +1.66% and Bill Nygren’s Oakmark Select Fund /zigman2/quotes/207233272/realtime OAKLX +1.80% .
Such funds beat out their peers when the market goes their way. But when the tide turns, they can suffer, attracting the ire of investors and, at times, regulators. The Secretary of the State of Massachusetts, for example, launched an inquiry last fall into a number of funds that invest significantly in Puerto Rico, including OppenheimerFunds. A spokesperson for Oppenheimer said the fund is cooperating with the request but maintains all investments were fully disclosed at length.
“There is clearly a cut of [Rochester’s] funds that are more aggressive,” said Geoffrey Bobroff, president of Bobroff Consulting, which advises the investment management industry. “In certain times those can be highly rewarding for the investor, but to the extent you’re getting exceptional reward there is a risk to that and it can go the other way.”
Spirit of America, whose funds are part of the privately held David Lerner Associates, Inc., is second in terms of Puerto Rico exposure, with 8.5% of its $117.6 million in municipal bond assets in Puerto Rico debt. Franklin Templeton Investments, which is publicly listed as Franklin Resources Inc. /zigman2/quotes/201997162/composite BEN +2.59% , has $3.6 billion, or 5.3% of its $67.8 billion in muni assets in Puerto Rico.
The next big milestone for Puerto Rico bondholders is a forthcoming sale of roughly $3 billion in debt, which is expected to come as soon as this week, following approval by Governor Alejandro García Padilla Tuesday. If the commonwealth is able to borrow enough capital, which many believe it will, the theory goes that it can get down to the hard work of fixing its financial situation, said David Tawil, co-founder of Maglan Capital, an event-driven hedge fund that owns Puerto Rico bonds. The island’s bonds have rallied in anticipation of that sale, and could rally further in its wake.
For Rochester, the strategy of investing heavily in Puerto Rico has been lucrative in the past, but it hit a stumbling block last year. To see that in action, take the Oppenheimer Rochester Fund Municipals /zigman2/quotes/206397100/realtime RMUNX +0.20% , a $6.2 billion New York-based fund, which has 27.3% of its assets in Puerto Rico debt, according to the fund website. The fund earned 11.5% in 2011 and 12.9% in 2012, substantially outpacing the benchmark Barclays Municipal Bond index in both years. But in 2013, the fund lost 10.8% while the Barclays index only fell 2.6%.
Securities Litigation & Consulting Group, a firm that provides expert witnesses in securities litigation, looked at Rochester’s allocation to Puerto Rico across its funds in 2012, and found that the higher the allocation to the island, the worse the fund returned in 2013. (SLCG may team up with lawyers pursuing a case against Rochester, though it is not currently.)
The Warren Buffett of muni bonds
Concentrating a fund’s exposure in a big bet isn’t uncommon (From the archives: Jonathan Burton on seeing focused funds more clearly). But Rochester stands out in part because its contrarian strategy is set against the backdrop of the municipal bond market, which tends to be dominated by mom and pop investors who buy bonds for their perceived security, not their eye-bulging returns. If anything, the common perception of munis is that they’re boring.
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Rochester’s strategy stems from the investing tactics of Fielding, who was a longtime portfolio manager at the firm. Proponents might call it a form of deep-value investing, while detractors could call it overly aggressive.
“My mindset is more like Ben Graham and Warren Buffett. If something has gotten cheaper, it’s better,” said Fielding, in a phone interview from his home in South Carolina. Fielding retired from Rochester in 2009 and no longer runs its investment strategy, but he continues to invest in its funds.
During his tenure within Rochester’s leadership, Fielding guided the funds to big gains. Fielding took large positions in muni bonds backed by payments from tobacco companies, airlines, hospitals. At the time these were considered higher risk muni bonds. In return, they offered higher yields. Among those investments was Puerto Rico, which he still finds to be a good bargain, and said he picked up last summer for his personal portfolio.
Investors pulled a total of $6.2 billion, or 17% of assets, from the 20 Rochester funds in 2013.
Following years of strong returns, Rochester’s funds took a hit in 2008 when the markets tumbled at the onset of the financial crisis. The Rochester Fund Municipals, for example, returned negative 31% in 2008, though it swung to a 45% return in 2009. By comparison, the Barclays Municipal Bond Index lost 2.5% in 2008 and gained 10.7% in 2009.
Investor lawsuits followed, with Rochester agreeing to pay $89.5 million to settle investor claims that they were misled about risks of the funds, the firm said last August. Rochester did not admit wrongdoing, and a case involving a seventh fund was not settled. Rochester would not comment further on the litigation.
In 2009, Fielding passed the torch on to Daniel Loughran, who has been at the firm since 1994 and now helms Rochester’s municipal bond management. A spokesperson declined to make Loughran available for comment.