Get Our Blog
  • Eric Hahn

Vague Disclosures by Highflying Mutual Funds May Put Investors in Peril

Desperate for richer yields on their portfolios, individual investors have thronged in recent years to mutual funds promising higher-than-usual income. The question is: Do these investors understand the higher-than-usual risks involved?

The answer is probably no. That’s because in the riskier funds, not all the perils are disclosed. Moreover, even when risks are formally discussed, many investors may still not realize how the funds really work. Trading on nonpublic information, for example, is a common practice in some of the instruments these funds hold.

Inspecting high-yielding mutual funds for potential pitfalls is always worthwhile. It is even more so now, with the Federal Reserve Board poised to make its first interest rate increase in over nine years.

Given the exotic investments that some income funds hold, understanding their risks is especially crucial. I’m talking about so-called leveraged loans or bank loans found in floating-rate income funds.

Leveraged loans are obligations taken on by heavily indebted companies, typically to finance a buyout or recapitalization.

These loans carry a wide array of risks. They don’t trade frequently and are difficult to value. They may not be backed by solid collateral and are subject to faster prepayment schedules than other obligations.

Nevertheless, mutual funds are regular buyers of these loans. More than 35 fund companies offer portfolios that invest in them. Among the bigger sellers are BlackRock, Eaton Vance, Fidelity and Pimco.

These portfolios can be large. At the end of July, the Fidelity Floating Rate High Income Fund had $11.6 billion in assets, while the Eaton Vance Floating-Rate Fund had $9.6 billion.

Until recently, the market for leveraged loans was red-hot. Assets under management at mutual funds and exchange-traded funds specializing in these instruments ballooned to $116 billion this month from $20 billion in 2009, according to Lipper.

But outflows are ramping up. Assets under management declined $2.1 billion in the first three weeks of August.

Mutual fund companies offering such funds detail many of the risks associated with these loans. But not all.

One disclosure lapse involves how these funds characterize their holdings. Often they describe the loans as junk bonds or “junk securities.”

This is imprecise at best. Leveraged loans have long been considered private transactions between lenders and borrowers, and the courts have held that interests in them do not constitute securities. The mutual funds that hold the loans may not be protected against fraud in these instruments under federal securities laws.

That’s kind of a big deal. But rare indeed is the leveraged loan fund that clearly warns its investors of this risk.

One that does is Neuberger Berman; its Floating Rate Income Fundprospectus states that the loans it buys may “not be considered ‘securities,’ and purchasers, such as the funds, therefore may not be entitled to rely on the strong antifraud protections of the federal securities laws.”

Other fund companies mentioning this risk make only oblique references to the loans’ falling outside securities laws. Investors must search hard for these disclosures, which are often buried in an obscure document known as the statement of additional information.

An offering from Fidelity, for example, states only that the loans it invests in “may offer less legal protection to the purchaser in the event of fraud or misrepresentation.” John Hancock says the same, adding that some of its fund investments “may not be protected by the securities laws.”

Asked why these disclosures are not more detailed, a John Hancock representative declined to comment. Vincent Loporchio, a Fidelity spokesman, said the company’s materials clearly disclosed all risks associated with leveraged loans.

There’s another downside to leveraged loan funds that investors hear little about: Mutual fund holders could be at a disadvantage compared with other investors who trade on nonpublic information about the companies issuing leveraged loans.

Prohibitions against insider trading apply only to securities, such as stocks and bonds. Investors taking the view that leveraged loans are not securities have contended that their trading on such information is not bound by these rules.

Indeed, receiving nonpublic information has historically been a routine part of the leveraged loan investment process. In the market’s early days, banks were the dominant lenders to such issuers. Because these borrowers were considered high credit risks, the banks demanded — and received — far more extensive financial information on their operations than an outside investor could see. Some of this would undoubtedly qualify as material nonpublic information.

Few mutual funds buying these loans disclose whether they receive confidential information from the companies issuing the obligations or whether they act on it. Fidelity’s fund materials, for example, are silent on the issue.

Funds that receive nonpublic information and do not act on it may be trying to protect themselves from insider-trading allegations. But they also may be putting their clients at a disadvantage compared with those who trade on the information.

Some funds flag this risk. Page 99 of the prospectus for the MainStay Floating Rate Fund, a $1.4 billion offering from New York Life, states that the fund “may be in possession of material nonpublic information about a borrower” as a result of its investment. But, it continues, “because of prohibitions on trading in securities of issuers while in possession of such information, a fund might be unable to enter into a transaction in a publicly traded security of that borrower when it would otherwise be advantageous to do so.”

The $2 billion Senior Floating Rate and Fixed Income Fund offered by Loomis, Sayles & Company also alludes to this informational disadvantage. “With limited exceptions, the adviser will take steps intended to ensure that it does not receive material nonpublic information about the issuers of senior loans who also issue publicly traded securities,” the filing states. “Therefore the adviser may have less information than other investors about certain of the senior loans in which it seeks to invest.”

Asked about this potential downside to its investors, Meg Clough, a Loomis, Sayles spokeswoman, said in a statement on Wednesday, “We’ve found that the benefits to Loomis, Sayles’s shareholders of maintaining access to our vast research, trading and integrated portfolio management resources outweigh the potential benefits of receiving nonpublic information.”

Mr. Loporchio, at Fidelity, said the firm “generally chooses not to receive material, nonpublic information from publicly traded issuers” whose loans and debt it buys.

Mutual fund managers may well prefer not to receive inside information regarding leveraged loan issuers because, unlike investment banks, they don’t have a system for walling off units that obtain that data.

Investment banks, as advisers to corporations, routinely learn details about their clients’ businesses that outsiders don’t know. For example, a company may approach a banker about making an acquisition or a divestiture, or raising fresh capital. While such market-moving plans are kept quiet within the bank, it will typically move to restrict other employees, such as traders and brokers, from conducting transactions in that company’s securities until the information is publicly known.

Mutual funds have none of these so-called Chinese walls, often for good reason.

But as a result, investors in leveraged loan mutual funds may be at a disadvantage compared with other investors in the arena. And that’s a risk they should be aware of.

A whistle-blower complaint filed last year with the Securities and Exchange Commission detailed these disclosure flaws. It urged the agency to bring enforcement actions against the funds. Simply because many funds fail in this area doesn’t mean they should get a pass, the filing noted.

It’s unclear what, if anything, the S.E.C. will do about these lapses. Perhaps the funds will fix them on their own. But it seems obvious that investors in leveraged loan funds deserve better disclosures about their risks.

Portfolio &
Money Management


Contact Us

4 Landmark Square - Suite 315
Stamford, CT 06901





ADV Part 2 | ADV Part 3 (CRS) Privacy Policy | Cyber Security Policy | Business Continuity Plan Client Secure Upload


Check the background of this firm on FINRA’s BrokerCheck.           


NS Capital LLC is a Registered Investment Adviser. NS Capital and its representatives are in compliance with the current filing requirements imposed upon registered investment advisers by those states in which NS Capital maintains clients. NS Capital may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. NS Capital’s web site is limited to the dissemination of general information pertaining to its advisory services, and through the NS Blog access to additional investment-related information, publications, and links.  Accordingly,  NS Capital’s web site on the Internet should not be construed by any consumer and/or prospective client as NS Capital’s solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation, over the Internet.  Any subsequent, direct communication by NS Capital with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of NS Capital, please contact the SEC or the state securities regulators for those states in which NS Capital maintains a notice filing.  A copy of NS Capital current written disclosure statement discussing NS Capital’s business operations, services, and fees is available from NS Capital upon written request. NS Capital does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to NS Capital’s web site or incorporated herein, and takes no responsibility such content.  All such information is provided solely for convenience purposes only and all users should be guided accordingly.


Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by NS Capital), will be profitable or equal any historical performance level(s).


Certain portions of NS Capital’s web site (i.e. newsletters, articles, commentaries, etc.) may contain a discussion of, and/or provide access to, NS Capital (and those of other investment professionals) positions and/or recommendations as of a specific prior date.  Due to various factors, including changing market conditions, such discussion may no longer be reflective of current position(s) and/or recommendation(s).  Moreover, no client or prospective client should assume that any such discussion serves as the receipt of, or a substitute for, personalized advice from NS Capital, or from any other investment professional. NS Capital is neither an attorney nor an accountant, and no portion of the web site content should be interpreted as legal, accounting or tax advice. 


Rankings and/or recognition by unaffiliated rating services and/or publications should not be construed by a client or prospective client as a guarantee that he/she will experience a certain level of results if NS Capital is engaged, or continues to be engaged, to provide investment advisory services, nor should it be construed as a current or past endorsement of NS Capital by any of its clients.  Rankings published by magazines, and others, generally base their selections exclusively on information prepared and/or submitted by the recognized adviser. Each client and prospective client agrees, as a condition precedent to his/her/its access to NS Capital web site, to release and hold harmless , NS Capital’s officers, directors, owners, employees and agents from any and all adverse consequences resulting from any of his/her/its actions and/or omissions which are independent of his/her/its receipt of personalized individual advice from NS Capital.

© 2020-2025 NS Capital LLC. All Rights Reserved.