The Willow Fund: Hard Lessons on Pitfalls of Credit Default Swaps

A year ago, investors in a UBS sponsored closed-end fund called the Willow Fund learned that the fund – which had assets of nearly $500 million in 2006 – was being liquidated.

The Willow Fund’s portfolio specialized in distressed debt instruments; losses of almost 80% began to pile up in the first three quarters of 2012 after the fund’s longtime manager suddenly switched investment strategies, abandoning corporate debt markets for bad derivatives trades. Meanwhile, investors in the Willow Fund – many of whom never realized they had been holding a portfolio filled with risky bets against the debt of European nations – were left with huge financial losses.

Gretchen Morgenson of the New York Times writes about the Willow Fund in a March 30 article. Her story serves as a cautionary tale for investors about credit default swaps and what can happen when a portfolio manager makes a sudden change in investing strategies.

Above all, the story raises questions on how the Willow Fund’s independent directors sat idly by as the fund manager took on more and more risks in the fund.

One of the investors in the Willow Fund was 70-year-old Ken Boudreau who began investing in the fund in 2009 for a total of $350,000. His losses now are $300,000. He has since filed an arbitration case against UBS.

As reported in the New York Times article, Boudreau said his UBS brokers told him 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 the Willow Fund since it began operations in 2000, was another selling point. Kim was expert at analyzing distressed debt instruments, or so the UBS brokers told Boudreau.

“I try to be a disciplined buyer and seller, buying in when markets are down,” Boudreau said in the New York Times story. “In mid-2009, distressed debt seemed to me a home run.”

That might have very well been true had the fund’s manager not opted to take on credit default swaps on government debt of Germany, Sweden, France, Spain and other nations. In these trades, Kim was buying a type of insurance against the nations’ defaulting; his investors would benefit if problems in those nations worsened.

In 2006, credit default swaps amounted to 0.18% percent of the Willow Fund. In 2007, however, the Willow Fund’s exposure to credit default swaps began to skyrocket. That same year, the Willow Fund began to see losses: 9.1%, and then 18% in 2008 when the credit crisis hit. That year, the Willow Fund had $106 million in unrealized losses on credit default swaps.

By the end of 2008, corporate bonds amounted to only 6% of the fund’s portfolio, down from 29% a year earlier. The value of the credit default swaps, meanwhile, had mushroomed to 25% of the portfolio from 2.6%in 2007. By 2009, when Boudreau started putting his money into the Willow Fund, credit default swaps amounted to an astonishing 43% of its portfolio.

Lawyers for some of the investors who have filed arbitration claims involving the Willow Fund contend that the fund’s disclosures and UBS failed to sufficiently warn investors about the substantial risks associated with credit default swaps and the investing strategy that employed these swaps. Moreover, they say investors were never adequately informed about the growing value of the credit default swaps in the fund’s portfolio.