Nov. 10–The seemingly endless revelations of corruption within the mutual fund industry have spooked many of the 95 million Americans who have entrusted the fund families with their hard-earnedsavings. And it has left some people wondering whether they should continue holding onto the tainted funds or, for that matter, any funds at all.
About half of American households own mutual funds, into which they’ve funneled $7 trillion, much of it intended to fund a comfortable retirement. Many choose mutual funds because they are designed to give small investors access to the stock market and level the playing field with large, powerful shareholders.
That pristine image, however, was shattered in early September, when New York Attorney General Eliot Spitzer unveiled the first of many charges of improper and illegal trading within mutual fund companies such as Janus and Strong. Since then, the list has grown far longer, with charges that Putnam, Alger and Alliance Capital put the interests of large investors and fund managers ahead of the individuals who socked away their money in the funds. Some of the nation’s biggest and savviest pension managers have bailed out of those funds.
So should individuals do the same? Some have apparently concluded they should. But experts point out that individuals might pay dearly for the privilege in fees and taxes, and then there is the question of where to stash your money next.
The controversy centers on funds that allowed institutional investors to make illegal late trades or bend their own rules to allow these large shareholders to engage in market timing, which is not illegal but hurts the other investors in the fund. Market timing is buying and selling shares quickly to capitalize on pricing lags. Late trading is when an investor trades mutual fund shares after the stock market closes, allowing the investor to profit on news that may have broken after 4 p.m.
These disclosures have prompted just over one-quarter of U.S. investors to consider fleeing the fund industry. Some 26 percent of respondents to a Gallup survey last week said they are less likely to invest in mutual funds now. About 20 percent said they would “definitely” sell their stake in a fund involved in the scandals.
But despite all their recent problems, mutual funds are still a wise investment for most Americans, experts said. They allow investors to create a diverse, low-cost portfolio with even a small amount of money.
“The usefulness of mutual funds for individual investors has not diminished even though the industry is tainted with scandal for the first time in history,” said Jeff Tjornehoj, research analyst at Lipper, noting that inquiries will likely prompt reforms that will benefit shareholders. “When Spitzer closes the books, it’s likely the mutual fund industry will be cleaner and more forthcoming.”
Asked how investors should react to his continuing probe, Spitzer said recently:
“At the end of the day, investors will be more confident because those acting improperly will be weeded out. Investor confidence will benefit in the end.”
The fact is, many people don’t have a choice but to pick mutual funds if they want to play the stock market. Picking individual stocks requires a lot of research and a lot of money if you want a diversified portfolio, experts noted.
For Michael Rice, mutual funds are still the way to go. Rice, who until his recent retirement prosecuted Medicaid fraud for the state attorney general’s office, has no intentions of selling his Janus funds.
“I’m not that concerned with what they do off-hours,” said the Hauppauge resident. “I’m more concerned with how they match up with comparable funds. If I get out it will be because they are lagging, not because the fund managers are trading off hours and perhaps profiting themselves. I’m interested in my own return.”
Others, however, don’t want to stick with a tainted fund company. East Williston resident Alan Reff, for instance, plans to sell his Strong money market funds and buy the equivalent Vanguard funds. And if his Janus funds recover their value, he may sell them as well.
“I will not be doing further business with them,” said Reff, who runs a technology consulting firm. “There are enough other firms with similar mutual funds, I don’t have to stay with someone who’s ethically challenged.”
But selling these funds could have unexpected consequences. While Morningstar has said investors in most of the tainted fund companies (except Putnam) should consider selling their stakes, the research firm warns that people have to consider the tax and transaction cost consequences. If they dump their funds, shareholders could wind up with large capital gains, upon which they have to pay tax, or find themselves paying loads.
Morningstar’s concerns center on the fact that high-level executives allegedly knew of the improper trading and did not stop it. This casts doubt on the firms’ compliance procedures and leads one to wonder what’s next, said Christine Benz, editor of Morningstar Fund Investor.
In Putnam’s case, Morningstar recommends holding on, but not to invest new money. It wants to see how new chief executive Ed Haldeman, who has a good record of rehabilitating other fund families, performs.
Those who believe they must sell should research carefully where they place their money, as the probe is continuing and more companies may be drawn in.
One fairly safe alternative is index funds. Since they are not actively managed, they don’t carry the same conflicts of interest, said Gary Gensler, co-author of “The Great Mutual Fund Trap.” And they tend to be lower cost.
Investors can also look to exchange-traded funds, which act like index funds but are traded like stocks on major exchanges. ETFs, however, can be more expensive since they are commonly bought through brokers.
Wherever shareholders decide to invest, they should research the fund family to ensure it is reputable, said Vern Hayden, a certified financial planner in Westport, Conn. Two free Web sites, fundalarm.com and funddemocracy.com, cover the industry.
Among the good governing practices funds should have are boards with many independent directors and even an independent chairman. Ask if the fund managers also run hedge funds or private money, which could cause conflicts. Stay clear of funds that tout short-term market performance since they often are more concerned with boosting assets than with the quality of their investments.
“It’s still safe to invest in mutual funds, but obviously more homework needs to be done,” Hayden said.
—–
To see more of Newsday, or to subscribe to the newspaper, go to http://www.newsday.com
(c) 2003, Newsday, Melville, N.Y. Distributed by Knight Ridder/Tribune Business News.
JNS, MMC, AC,
