Nov. 5–Many of the nation’s 95 million mutual fund investors are both confused and outraged to learn that the some of the funds were cheating them.
A few fund shareholders have withdrawn their money; others are thinking about it; and still others are waiting to see if their fund companies are implicated in the scandal. But experts caution investors against condemning the entire industry for the sins of a few.
The more prudent approach is to know how to spot a well-run mutual fund, or conversely to quickly spot a fund that has gone astray. The following questions and answers should help investors gain more insight into the mutual fund industry.
QUESTION: What are the most common characteristics of a well-run fund?
ANSWER: One of the first things to look for is how much the fund charges investors. This will vary among the different fund categories, so investors must compare a fund’s fees with the average for those of a similar style. The average annual fee for one of the most popular fund categories — large-cap value — is 1.4 percent of your investment.
Typically, funds with the highest fees are the worst performers.
Secondly, look for fund managers with a minimum of five to 10 years of investing experience. In other words, avoid a new fund with an inexperienced manager.
Thirdly, the best-run funds are diversified across many industry segments and don’t take risky bets in one sector.
Q: What are some of the red flags that could point to trouble ahead?
A: Watch out for mutual funds that have a high turnover of stocks in the portfolio. A few fund managers are successful despite heavy trading, but in general the lower the turnover rate the better.
Long-term investors should look for a fund that has redemption fees. This signals that the company doesn’t want market timers in the fund. (See explanation below of market timing.)
Lastly, avoid funds that seem to be just latching on to the latest fad. The best example of that were the Internet-related funds of the late 1990s.
Q: Which mutual funds have been implicated in the scandal so far and what were they doing?
A: Bank of America Corp., Bank One Corp., Strong Capital Management Inc., Janus Capital Group Inc., Putnam Investments and Prudential Securities Inc. are some of the most prominent companies.
Basically, they gave large investors a trading advantage over small investors by allowing late trading and market timing.
Q: What is late trading?
A: Generally, when investors place orders for shares in a mutual fund before the market’s close at 3 p.m., they will get the price, or net asset value, as of 3 p.m. If the order is placed after 3 p.m., they get the following day’s closing price. Federal and state regulators have found that some large investors — namely hedge funds — often placed orders well after 3 p.m. and yet still received that day’s closing price.
Q: How can large investors profit from that?
A: If positive news breaks after the closing bell in the technology sector, for example, the investors can simply buy shares in a technology mutual fund. The price of those shares will almost certainly go higher the following day, but the investors bought at the previous day’s lower price. It’s almost like betting on a horse race that’s already over.
Q: What is market timing?
A: While regulators often use the term market timing, that’s a little misleading. It’s really short-term trading and typically involves international funds because the European markets close hours before the U.S. markets.
With this strategy, a mutual fund allows investors to buy shares in an international fund before the 3 p.m. close and then typically sell them the next day. This can be profitable because an overseas company may release a positive earnings surprise after the European markets close but while the U.S. markets are still open. Similar to late trading, investors are almost assured of making a profit when the fund is priced the next day.
Q: This just seems like a smart trading strategy. What’s wrong with it?
A: While late trading is probably a more overt breach of investor trust, market timing can reduce a fund’s performance, at least indirectly. That’s because the more short-trading that a fund permits, the more cash the fund manager has to hold in reserve to meet redemptions. The more of a fund’s assets that are in cash, then the less that is being put to work in the market.
Q: What should investors do if they own one of these funds in their 401(k) plan?
A: Morningstar, the mutual fund rating service, recommends that investors seriously consider withdrawing their money from most of the implicated fund companies.
However, if one of these fund families is the only alternative in your retirement account, that may not be the most prudent course. They should at least encourage their employer to give them other options for investment.
Morningstar has not advised investors to withdraw money from Putnam, but recommended that they not add to investments.
Q: Why did it take New York Attorney General Eliot Spitzer to uncover the abuses? Where was the Securities and Exchange Commission?
A: The investigation began in September after Mr. Spitzer received a tip from someone regarding the relationship that Bank of America had with a hedge fund called Canary Capital Partners. Had the SEC received the tip regarding so-called late trading, presumably, it would have taken action.
However, Mr. Spitzer and others have criticized the SEC for being asleep at the wheel. And on Monday, the chief of the SEC’s Boston office stepped aside after it was disclosed that he failed to follow up on a tip regarding improper trading at Putnam.
Q: What happens next?
A: More mutual fund companies will almost certainly be implicated in the improper trading scandal. The regulators have subpoenaed records throughout the mutual fund industry. No one is sure about the long-term impact on the mutual fund industry.
Q: Have investors been withdrawing money from their mutual funds?
A: Overall, the flow of money into mutual funds has far exceeded the amount that investors have withdrawn. In September, net inflows amounted to $25 billion. But investors pulled out more than $446 million last week. And several state pension fund managers said they would withdraw several billion dollars from Putnam.
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