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Boston Capital

Further fiasco

Email|Print|Single Page| Text size + By Steven Syre
Globe Columnist / August 28, 2007

Think all of this summer's five-alarm investment fiascos are confined to the world of go-go hedge funds? Think again.

A supposedly conservative bond fund managed by the investment arm of State Street Corp. lost more than a third of its value in a matter of weeks amid the turmoil in credit markets this month, according to an investor who has seen the returns.

The State Street Limited Duration Bond Fund, which managed $1.4 billion for institutional clients, lost about 37 percent of its value during the first three weeks of August, according to the investor. The fund, managed by State Street Global Advisors, had fallen 42 percent for the year by Aug. 21, the investor said.

Those kind of losses would place the fund among the most seriously injured investment casualties in this summer's wildly volatile markets. The high-profile hedge fund firm AQR made headlines when it disclosed a July loss of 21 percent in one of its funds. Sowood Capital Management's hedge fund lost about 60 percent of its value when the Boston firm liquidated its portfolio last month.

"Both the level of [our] underperformance and the degree of market turmoil are unprecedented in our 30-year history as a fixed income manager," State Street executive Sean P. Flannery wrote in an Aug. 14 letter to clients.

The possible cause of the fund's big losses: investments in mortgage-related securities, and leverage that magnified the problems. Flannery's letter describes a fund that "increasingly focused on housing-related assets." Meanwhile, the fund borrowed to increase its portfolio to between two and three times the amount of money clients had given State Street to invest, according to one investor.

The State Street Limited Duration Bond Fund was created in 2002 as a way to generate better results than those of money-market funds with only slightly more risk. The fund was widely considered an "enhanced cash" product, an investment category usually considered very low risk. It was sold only to institutional clients, not individual investors.

The fund invests in relatively short-term securities such as corporate notes and debt obligations backed by home equity lines and other loans. At least two-thirds of the portfolio is supposed to be investment-grade debt.

But even some kinds of highly rated investment-grade securities have suffered recently. Mortgages and home-equity lines sold in loan pools that may have been considered dicey as a whole were cut up into slices offering some investors less risk for a lower return. But the value of those lower-risk slices, which may have carried high credit ratings, were still hurt when investors fled from the subprime meltdown.

State Street officials declined to discuss anything about the fund yesterday. But Flannery, the chief investment officer for North America at SSGA, described difficult investment conditions in his letter to clients.

"This market situation is extreme and challenging to manage," he wrote. "While we believe that the home equity-linked markets clearly convey far greater risk than they have historically, we feel investors must take into account the downside of forced selling in this chaotic and illiquid market."

Flannery told clients that State Street believed investors who fled many credit markets would return over time and restore a normal pace of trading.

"While we will continue to liquidate assets for our clients when they demand it, we believe that many judicious investors will hold the positions in anticipation of greater liquidity in the months to come," he wrote.

Some of the State Street fund's investments may bounce back, given enough time. The real question is how State Street got their clients in this hole in the first place.

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