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Most investors are licking their wounds from the bear market, but in Oregon's 529 college savings plan, investment pain has turned into legal action.

On Monday, Oregon's state attorney general filed a suit against OppenheimerFunds, alleging that savers in the state's 529 plan lost at least $36.2 million as a result of the fund company's negligence. You can read the legal complaint here. Specifically, the suit centers around Oppenheimer Core Bond (ticker: OPIGX), which until recently played a major role in the state's conservative and ultra-conservative portfolios. According to the suit, the objective of both portfolios--intended for students in college or just a few years from college--was to preserve capital with minimal growth. You'd think a core bond fund would fit neatly into such a mandate.

But in 2007 and 2008, as markets went haywire, the managers of Oppenheimer Core Bond decided to go after "potential value." Specifically, in the spring of 2008, managers were building positions in things like high-quality commercial mortgage-backed securities--and using a type of leverage known as swaps to do it, according to an annual report. The bets backfired, and the fund lost a stunning 35.83% in 2008, compared with a positive 5.24% return for the Barclays Capital U.S. Aggregate Bond Index, the fund's benchmark.

Oregon is ticked. The state claims that the "character of the fund ... changed in 2007 and 2008 ... yet neither the state no investors were alerted that the fund had become significantly more aggressive and risky."

In a statement, Oppenheimer fired back that it did not change the investment policies of Core Bond. The fund company also said it consistently provided the state with information about the fund and "offered to make its portfolio managers available to meet with the Board," which overseas the 529 plan. "An offer that was not accepted," Oppenheimer says.

I checked in with Miriam Sjoblom, a Morningstar analyst that covers Core Bond. She said that Oppenheimer disclosed its asset exposure--it just wasn't written in plain English. "A lot of that exposure came from derivative contracts, which were detailed in the footnotes of the shareholder report," she said. "But that required you to flip to the back of the report and do the math on your own."

From my point of view, Oppenheimer clearly got ahead of itself. As Sjoblom points out, it's not uncommon for core bond funds to turn to derivatives, such as swaps, to boost yield. Just some fund shops are better at it than others, apparently.

What's more interesting to me, though, is to look at the fund's recent history. A Morningstar analyst report dated April 29, 2007 (not from Sjoblom), points out that for the trailing five years, the fund's annualized return was 5.7%--better than 90% of its peers. Then, on September 26, 2007, Sjoblom wrote that, "the fund's top-quartile record during this period has been helped by a tendency to hold more mid- and lower-grade fare than its typical rival."

So I wonder just how closely the board of Oregon's 529 savings plan was looking at the underlying assets of Core Bond, or whether past returns were a bigger factor. I'm also skeptical of Oppenheimer's decision to use Core Bond for 529 portfolios where the aim was principal preservation, not growth.

For the record, Core Bond is no longer an investment option in four of the five state 529 plans that Oppenheimer administers: Oregon, Texas, Illinois and New Mexico. However, in some states, any money invested prior to the change this year will remain in Core Bond. Only new contributions will be directed to the replacement fund, Dreyfus Bond Market Index (DBIRX). And in Nebraska, Core Bond is still used in four of the state's 529 portfolio options.

Want to make a change yourself? Get details on 529 plans nationwide here. Plus, in light of the market's recent volatility, the IRS is allowing savers in 2009 to switch 529 plans twice. Normally, you can only make a move once per year.

--Carolyn Bigda