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Fair Game

If a Fund Turns on a Dime, Watch Your Dollars

LAST October, shareholders in the Willow Fund, a closed-end investment fund sponsored and sold by UBS, received some disturbing news: the fund, which had assets of almost $500 million in 2006, was being liquidated.

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.”

A spokeswoman for UBS said of the Willow Fund: “This fund was a specialized, speculative investment sold only to sophisticated and experienced investors who represented that they understood the fund’s substantial risks. Investors were kept informed of the fund’s investments, including in credit default swaps, and the performance of the fund. While we regret the recent losses, investors were clearly informed that these types of investments have substantial risks.”

But Mr. Zamansky argues that the Willow Fund erred in failing to warn investors until 2009 that its credit default swaps could require the posting of investor money if the trades went bad. That year, the Willow Fund had $106 million in unrealized losses on credit default swaps.

In 2010 and the year after, Willow posted positive returns. But in 2012, the fund registered an 89 percent decline. As the fund was being wound down, UBS said about 70 percent of its losses came from exposure to credit default swaps.

ALFRED TOMBARI, 80, a retired urologist in West Palm Beach, Fla., is another investor who lost most of his investment, which was $50,000, in the Willow Fund. He said he was frustrated by the fact that investors were barred from selling their shares except each December. “It started going down in the early part of 2012,” Dr. Tombari recalled. “I knew I was in trouble but there was nothing I could do about it.”

Like all mutual funds, Willow was overseen by independent directors. But their oversight did little to protect Willow investors from disaster. Over several years, regulatory filings show, Willow directors noted that the volatility in Mr. Kim’s portfolio exceeded that of comparable funds, but there is no indication that they did anything to address the issue.

“The gentleman who ran the fund decided to go to a more risky model,” Dr. Tombari said. “From what I understand from my broker, the board of the Willow Fund approved this more risky pattern.”

UBS declined to make the directors available for an interview.

Clearly, investors in the Willow Fund learned the hard way that a fund’s directors cannot be relied upon to protect investors from a manager’s risky bets. Investors have to watch fund managers carefully to recognize when they might be straying from their stated strategy.

Tracking a fund’s portfolio through regulatory filings may not be a scintillating way to spend an evening, but it can indicate when a manager has made a significant and possibly perilous shift in an investment approach.

UBS said it expected to return whatever money was left to investors by this June. It is likely to be pennies on the dollar.

A version of this article appears in print on  , Section BU, Page 1 of the New York edition with the headline: If a Fund Turns On a Dime, Watch Your Dollars. Order Reprints | Today’s Paper | Subscribe

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