Investors may not take a hit directly from the Puerto Rico debt default, but there are still lessons to be drawn.

Last month, Puerto Rico defaulted on their debt. There are only about 3.5 million people on the island, but they have racked up over $70 billion in debt, twice as much as a decade ago (Note: John Oliver has a superb overview of what’s happening in Puerto Rico).

The problem is compounded by the fact the both the economy and the population of Puerto Rico are shrinking. As noted in a Bloomberg article, growth in Puerto Rico exploded in the 1990s because of tax credits extended to companies to set up shop there. Those ended in 2006, and then the economy collapsed. More than 80,000 jobs were lost, and population is projected to slide to a 100-year low in the next three decades.

Chart: Bloomberg

Chart: Bloomberg

Conditions in Puerto Rico are abysmal. Schools, electricity, and water service have all been affected, because the government cannot earn enough tax revenue to provide basic services and service their debt.

Who owns the debt?

For many years, investor demand for Puerto Rican debt was high. Because owning their debt was tax preferred, investors couldn’t get enough of it. The government didn’t have to worry about balancing the budget, because the difference between tax revenue and spending was bridged by easy borrowing.

But who was buying?

Hedge funds, for the most part.  The main draw were the tax benefits. Puerto Rican debt was in the form of municipal bonds, which is important for two reasons.

First, this debt is completely tax-free to investors on a federal/state/local level – a generous structure even for municipal bonds. Investors could have their yield cake and eat it tax-free.

Second, the bond is structured as a “general obligation” bond, which means repayment is guaranteed by the government. In theory, in the event of default, these bondholders will get paid before money goes anywhere else. For hedge funds, this was all as good as it gets.

But individual investors, many saving for their retirement, got in the game, as well. These municipal bonds were popular to mutual fund managers in recent years for the same tax reasons. And some fund managers couldn’t get enough of the stuff – Franklin Templeton and Oppenheimer, in particular, purchased billions of Puerto Rican, tucking it into as many places as they could.

If you own Oppenheimer’s Rochester Maryland Municipal Fund, you’re expecting to earn cash flows from municipal bonds floated in the state of Maryland. Instead, the assets in the fund look like this:

From the Rochester Maryland fund prospectus

From the Rochester Maryland Municipal Fund’s website

And considering the economic hardships in Puerto Rico in recent years, these bonds funds with exposure to the island’s debt have performed abysmally compared to their peers.

What is the lesson for mom and pop investors?

Despite some agreement from Congress on the skeleton of resolution, nobody is sure what will happen to bondholders. Will they get stiffed, or will the U.S. government change its archaic laws to deal with this situation?

No matter the political outcome, there are two lessons here for individual investors:

First, investors should pay attention to what they’re getting. Just because a fund’s name says that you should receive exposure to Maryland, you might be getting more than you wanted.

Second, these types of funds are considered active-managed. Every fund has a stated benchmark. For a passive-managed fund, the manager is trying to match the performance of the benchmark index by replicating the index’s components.

Active funds, however, try to beat the index. On net, active funds return almost exactly the benchmark return, but then you have to take out fees beyond that, so the after-fee return is actually below the benchmark.

If you pick the right active fund, you can earn outsized returns. However, portfolio managers make awful, dumb mistakes all the time – like loading up on Puerto Rican debt, which was supported only by tax law, not fundamental growth. On top of that, you have to pay them a management fee to make these active investment decisions. Follow a basic passive bond index strategy, and you don’t have to worry about a portfolio manager taking on too much risk for your portfolio’s target return.