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The best investors make the most of every edge they can find. But sometimes, apparent advantages don't work out the way you expect -- as investors in some supposedly safe bond mutual funds have found out in recent months.

With stocks, picking the right company can mean the difference between a multibagger and parking your assets in a dead-money stock for years. But investing in bonds and other fixed-income securities is different. With bonds, an edge of just a fraction of a percentage point of return is sometimes enough to put you at the top of your fund category.

Making a little bit more
To seek higher returns in a low-yield environment, many investors resorted to using so-called ultrashort bond funds as a substitute for money market funds. By putting together a portfolio of bonds with a slightly higher duration, ultrashort bond fund managers hope to eke out some extra yield. For instance, while most money market funds own bonds with average maturities of two or three months, an ultrashort fund holds somewhat longer-dated paper, with averages of a year or so.

When an ultrashort fund invests well, this strategy can be effective. For instance, one high-rated fund, RidgeWorth US Gov't Securities Ultra-Short Bond (SIGVX), averaged a 4.7% annual return over the past three years. In contrast, even top money-market funds like Vanguard Prime Money Market have only managed to average around 4.4% over the past three years.

Taking on risk
By itself, owning slightly longer-dated bonds wouldn't increase the risk of a bond fund substantially. It would introduce a bit more interest-rate risk, and the fund's price would fluctuate a bit over time. For instance, the traditional bonds that Fidelity Ultra-Short Bond (FUSFX) owned, issued by companies like Commonwealth Edison (NYSE: ED  ) , CVS Caremark (NYSE: CVS  ) , and Transocean (NYSE: RIG  ) , held their value fairly well.

But some ultrashort funds got into trouble by buying riskier bonds. According to the Fidelity fund's semiannual report from earlier this year, more complicated asset-backed securities, issued by institutions like American Express (NYSE: AXP  ) , Bank of America (NYSE: BAC  ) , and Morgan Stanley (NYSE: MS  ) -- along with collateralized mortgage obligations (CMOs) -- were the primary contributors to the fund's big losses.

A downward spiral
The worst news for investors in these funds is the vicious circle that began with losses in these risky assets. As returns went negative, fund shareholders started to pull money out of ultrashort funds. This caused a major problem for fund managers because they didn't have cash on hand to cover shareholder redemptions. Meanwhile, the market for the assets these funds owned became extremely illiquid, making it difficult for fund managers to find buyers at any price. To raise cash, funds sold at steep discounts to their original purchase price. In turn, that hurt fund shares even more, sparking new waves of fund redemptions.

In the aftermath, two ultrashort funds, including SSgA Yield Plus and Evergreen Ultra-Short Opportunities Fund, have already stopped operating and liquidated their assets. Meanwhile, Fidelity's fund has shrunk to $320 million in assets, down from $475 million in January and more than $1 billion in July 2007. Shareholders of Charles Schwab's (Nasdaq: SCHW  ) YieldPlus fund have sued the firm, alleging deceptive misrepresentations about the safety of the fund. With so many investors taking such large hits, it's uncertain whether the whole ultrashort bond fund category will survive.

Remember risk
This story serves as another valuable reminder: Anytime you see an investment that offers higher potential returns, you should look out for higher risk, even if it's not initially obvious. Because these funds were widely seen as an alternative to safe money market funds, most investors had no idea that ultrashort funds could lose as much money as many have in the past year.

Taking risk isn't always bad. In fact, being smart about managing risk can help enhance your investment returns. But when the extra payoff is minimal compared to the potential losses, you should think twice before taking the riskier choice.

More on income investing:

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Fool contributor Dan Caplinger avoided the ultrashort debacle. He doesn't own shares of the stocks mentioned in this article. Bank of America is a Motley Fool Income Investor recommendation. American Express is a Motley Fool Inside Value selection. Charles Schwab is a Motley Fool Stock Advisor pick. The Fool owns shares of American Express. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is always above average.

Read/Post Comments (3) | Recommend This Article (0)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 12, 2008, at 4:38 PM, prginww wrote:

    Hate to tell you Dan, but Commonwealth Edison (aka ComEd of Chicago) is part of Exelon - and the symbol ED is Consolidated Edison, known affectionately to all us city folk as ConEd - you might wish to correct, or leave as is - your choice

  • Report this Comment On September 12, 2008, at 11:21 PM, prginww wrote:

    When the market is going up, everyone's risk tolerance is high.

  • Report this Comment On September 13, 2008, at 12:05 AM, prginww wrote:

    as moishep said...ED is have the wrong ticker.

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