Oct. 14–Lloyd Ness is not a man given to knee-jerk reactions.
At 76, he has stuck with the same four mutual fund companies — Vanguard, Fidelity, Merrill Lynch and American Century — since the mid-1970s. Even after the stock market plunged in March 2000, Ness continued to reinvest his dividends.
Yet Ness, who is retired but works part-time at a Harris Teeter in Raleigh, has considered dumping all his mutual funds — and investing the proceeds in certificates of deposit — since learning that several of the nation’s largest mutual funds may be ensnared in a widening scandal.
“I never thought I would say this, but perhaps there are safer places to put my money,” Ness said.
For the past four decades, investment companies have touted the safety and integrity of mutual funds. No other investment vehicle, they argued, offers as much convenience and diversification for so little. As of August, mutual funds were owned by nearly one in two Americans, compared with one in 15 in 1980.
So it came as a shock last month when Eliot Spitzer, New York’s attorney general, announced that he had evidence of illegal trading activity that potentially cost mutual fund shareholders billions of dollars annually. Ordinary investors were asking a thorny question: Should they sell and look for other places to put their money?
The short answer is no, most experts say.
The abusive trades, though serious, are not likely to have a big impact on the returns of any single fund account, say mutual fund experts. Plus, dumping mutual funds isn’t a realistic option for the millions of Americans who invest through tax-deferred, 401(k) retirement accounts with limited choices.
Although bailing out of mutual funds altogether isn’t a good idea, investors should take a long look to see whether their funds are really acting as good stewards, financial advisers say. A fund company that charges high fees, generates big tax bills through excessive trading or replaces its fund managers frequently should be avoided — even if the returns look impressive.
“There are more than 8,000 mutual funds in this country,” said Franklin Smith, a registered investment adviser from Raleigh. “There is no reason to stick with a fund if you aren’t absolutely convinced it’s looking after your best interests.”
Thus far, most mutual fund shareholders have not headed for the exits. Investors poured $2.39 billion into equity mutual funds in the four weeks ending Oct. 1, according to AMG Data Services, a firm based in Arcata, Calif., that tracks fund flows.
Only Janus Capital has seen a sizable outflow of money since the scandal erupted. In September, investors pulled from Janus $4.4 billion — the biggest monthly withdrawal in more than a year, the Denver company said Thursday.
The mutual fund companies identified by Spitzer have promised to fix any problems and compensate shareholders for any financial harm.
“When I sit down with clients and say, ‘Look, isn’t this awful?’ most of them just shrug their shoulders,” said William K. Dix, a Raleigh financial planner and program director for the Research Triangle Park chapter of the American Association of Individual Investors.
Scandals at public companies such as Enron, Adelphia and WorldCom destroyed billions of dollars in shareholder wealth and spurred public outcry. But allegations about mutual funds, for example, that they allowed big investors to trade after regular hours, have not generated widespread outrage.
Even if there were unethical or illegal trading, the damage to any single mutual fund account is likely to be minuscule. In a recent research report, Stanford University professor Eric W. Zitzewitz estimates that the annual cost from late trading amounts to just $400 million a year. Spread over millions of accounts, the costs probably won’t amount to more than a few cents each.
“You look at Enron and that affected a small number of people very, very deeply, so it received a good deal of attention,” Zitzewitz said. “But this affects a large number of people only a little. So people aren’t as upset.”
Even investors who feel cheated face the choice of selling when the stock market may be rebounding from a three-year decline. Over the past 12 months, the Standard & Poor’s 500-stock index has surged 33 percent and the tech-heavy Nasdaq is up 72 percent.
Richard Mueller, another Triangle investor, considered dumping all 20 of his mutual funds when he learned of Spitzer’s allegations. About 60 percent of his savings is already invested in bonds, money market accounts and certificates of deposit; if he invested any more in these instruments, he would miss out on an increase in stock prices.
“But what other options do I have?” said Mueller, founder and chief executive officer of Synergy Vaccines, a Durham-based biotechnology company.
Steven C. Robinson, a commercial real estate broker in Raleigh, said he is more concerned that his mutual fund, which he declined to identify, held onto Enron stock until it ruached 65 cents a share.
“It bothers me that fund companies aren’t asking tough questions of management,” Robinson said. “That affects people far more directly than a few illegal trades here or there.”
But that does not mean investors should ignore the scandal.
One of the main attractions of mutual funds is that every investor is supposed to receive the same professional management, said N.C. State finance professor Charles P. Jones, author of “Mutual Funds: Your Money, Your Choice” (Financial Times Prentice Hall, $23.05). Over the past month, however, mutual funds have found cases in which large investors were allowed to make trades that were off-limits to small shareholders.
According to Spitzer’s lawsuit, four companies — Bank of America, Janus Capital, Strong Capital and Bank One — permitted a large hedge fund, Canary Capital Partners, to engage in trades that were off-limits to their smaller investors. Spitzer’s office has since widened its investigation to include Alliance Capital, Putnam Investments, Prudential Securities and Fred Alger Management.
Morningstar, the nation’s largest mutual fund research firm, says shareholders should consider selling shares of any mutual funds implicated in the scandals. “Even if the financial damages [to shareholders] are small, this calls into question the management of these fund families,” said Russel Kinnel, a fund analyst at Morningstar.
But most advisers recommend investors remain calm until more details emerge. Along with the New York attorney general, William Donaldson, chairman of the U.S. Securities and Exchange Commission, said the agency is aggressively investigating potential trading abuses. No fund company has been charged with wrongdoing.
“If you bail out of one fund, you may find yourself in another fund that is engaged in the same activity,” said Vernon Lee, a financial planner from Raleigh.
But people should review their mutual funds to determine whether they are serving their shareholders, Lee said. Any mutual fund that charges annual fees in excess of 1.5 percent of its assets deserves a “second or third look,” he said.
In addition, if a fund has been performing below its peers, the fund should provide a clear explanation. “Blaming the economy, at this point, is not good enough,” Lee said.
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