How to view the mutual fund scandals

By Don Kuehn

As a certifiable mutual fund junkie who has invested in no-load funds for about 25 years, the never-ending stream of stories over the past year has caught my eye. Like millions of other investors who paid even modest attention to the scandal uncovered by New York’s crusading attorney general Eliot Spitzer, I wondered whether any of this affects me directly or should cause me to move assets.

The basis for most of the early reports was the discovery that some mutual funds were stretching the rules governing hours of trade for a few of their biggest customers. This “late trading” gave some fund managers a heads-up by permitting trades after the day’s business was supposed to be over. Hey, it can’t be too hard to make money when you already know whether your holdings are going to post a profit or loss for the day.

The practice has been characterized as “market timing” or “late trading.” Either way, a few (as far as we know) mutual funds manipulated their own rules and those of the Securities and Exchange Commission for the benefit of a select few outside money managers and hedge fund operatives, and to pad the pockets of individual fund managers and executives.

So, what about me?

Will the scandals rocking some investment houses affect us and the money we have invested in mutual funds? Probably not. The assets are invested in separate custodial accounts and they can’t just walk away. Even if a mutual fund company should fail or get swamped in a series of class-action lawsuits, our assets will be safe.

If even the slightest scent of scandal has you thinking about bailing out of the funds you hold, consider the tax consequences of your actions. In a deferred account like a 403 (b) or an IRA, you might not face taxes but there could be early withdrawal penalties. In your personal investment accounts, there could well be tax consequences. However, odds are they will be small. Between the new 15 percent tax rate on long-term capital gains and the losses from the three-year bear market, taxes aren’t a big concern for most investors.

If you’ve done your homework and want to send a message to your fund manager or your 401(k) plan administrator, vote with your feet. Move your money out. A little righteous indignation never hurt anyone, and if you have limited investment options in your company retirement plan, tell your plan administrators that you expect them to act as the fiduciaries they are. Insist that errant fund firms be eliminated from your plan.

According to Jim Jubak, who writes for MSN Money, “Just as it took the dissolution of Arthur Andersen to get the attention of the accounting industry after Enron, it will take the disappearance of a Janus, a Strong or a Putnam to get Wall Street to pay attention. It’s a big, hungry animal. You’ve got to hit it with a big stick.”

Funds that are well-managed, that have delivered decent performance and that have not committed major violations of shareholder trust will be able to dig firebreaks around themselves, according to Jubak.

Any new SEC regulations that cut into the profits that mutual fund companies now make from directed brokerage, from hidden fees, from double-dipping and the like, and that require mutual fund companies to compete for investors on the basis of price and performance, should be designed to hold the inefficient companies’ heads under water.

The kinds of charges being pursued by Eliot Spitzer & Co. represent systemic corruption in the industry. It demands attention. It can’t be dismissed as the actions of just a few bad apples. Even without SEC action, the mutual fund industry will change, but investors still won’t be able to tell the good guys from the bad.

Since there seems to be an almost endless supply of individual infractions to bring to light, this scandal will run as long as the investigators generate headlines and public anger. The scandals will stop when the public has lost interest and the attorneys general and investigative bureaucracies move on.