The Scandal in Mutual Funds — A Perspective
by J. Michael Fay, CFP™
Perhaps the worst event in any business is a scandal where
the customers have been victimized, creating a devastating effect on both the
customers and the business itself.
One of America’s most successful businesses finds
itself on the verge of
just such an event.
The mutual fund industry has long been a scandal-free method of investing, especially for the small
investor with less than $100,000 to spread over several ventures in order to reduce risk.
The purpose of this article is not just to point out a
problem, already widely publicized in the press, but also to suggest what
actions investors may be able to take to protect themselves now and in the
future.
What’s the problem? Well, a number of mutual funds
that are widely known and broadly held by millions of investors, have been
under investigation or indicted by
the attorney general of New York, Elliot Spitzer, by authorities in
Massachusetts, and finally by the federal regulatory authorities. Several common practices are being looked at, with the
most egregious problem – when the mutual funds permitted traders to place
after hours orders at day closing prices – much like betting on a horse
that has already won, in return for millions of dollars to be invested in the
fund in return. This late trading
practice is a breach of fiduciary responsibility to say the least, and such
firms cannot be trusted.
The second issue is that of market timing. To put it simply, that is when a broker
attempts to “time the market” by moving out of the market into cash
when the market is “overbought” (too pricey), and returning to the
market when it is “oversold” (cheaper). This activity is not illegal, and is widely practiced by
market timers and fund managers alike. However, when a fund permits the
practice, or engages in frequent and rapid trading itself, the costs of such
trades are passed on to the average buy and hold investor, clearly not in their
interest.
Indeed, such timing doesn’t always work out, and may
cause losses known as “opportunity losses,” or that which an
investor could have made had the timing not failed. Hedge funds and others have
also been arbitraging foreign and domestic markets by using sophisticated
technology and trading legally, taking advantage of the differences in trading
hours here and overseas.
There are several mutual funds that are set up to
accommodate market timers.
However, it should be stated here that many fine mutual fund companies
have not engaged in this practice, and an increasing number of those that have,
recently begun prohibiting the practice by registered representatives of
brokerage firms.
Now that we know the problem, what to do about it? My first inclination is to sell all
shares in any company that has demonstrated an egregious breach of their
fiduciary responsibilities. No
question. Even a hint of this is
causing large outflows from some companies named by the authorities in the
current scandal.
I called the large mutual fund company that handles my
corporate pension plan, and asked them when I was going to read about them
being on the Spitzer List. I was
told that long ago they set up a trader surveillance system, and when they
caught a trader performing unauthorized trading, they docked his salary and bonus,
whereupon he resigned. This is an example of how a well-run compliance system
is intended to work. It is not
enough, however, to take a spokesperson’s word, and there are other, more
objective methods of determining the better-run mutual funds.
If you trade your own funds, and buy and sell through a
custodian, you
already know what research is available to you. For the vast majority who rely on brokers or investment advisors, however, there are a few simple indicators of quality. One of the more important ones is to make sure that your advisor has a veritable universe of investment funds available that are suitable by some objective criteria – chief among them:
1. Turnover rate What is the turnover rate of stocks in a fund? More than 100 percent in a year would
surely give me pause. In fact, a very low turnover rate of 25 percent or less,
with excellent results compared to its benchmark, would indicate that the fund
manager is strategically certain of his methods.
2. What are the costs of the funds? Not only the commission you are
charged, but the internal costs.
They are known to the brokers, but not often referred to. Internal costs of over 1 percent would give me pause, or cause
for further information. There are
situations where higher internal costs are warranted. New hybrid funds with multiple managers, asset allocation
and institutional oversight are now available. These funds seek to earn their higher fees by providing more
oversight and added value.
3. As to the commissions, there is quite a range From no-load to almost 6 percent.
The broker needs to be compensated, and also needs to provide full
disclosure. If you are in a
commission arrangement, and if you are intending to be a long-term investor,
the front-load “A” shares may be the most economical. There are “B” shares that
don’t charge up front, but annually for five or six years, and in a
rising market would be much more expensive, and still chargeable at the end if
you decide to get out. Also
“B” shares don’t provide volume discounts. “B” shares tend to keep one
invested in the fund family, and if the name shows up on the Spitzer List, it
could be expensive to move out.
4. There are other indicators of a quality fund Such as its alpha ranking
which compares the fund managers to its peers. An r square number will tell you
how close to a particular benchmark the manager is tracking. Other factors can tell you about the
market risk and volatility, all of which an advisor is capable of relating to
you, when asked.
5. Be wary of information provided directly by fund companies For instance, one well-known
company is known for advertising how low cost saves investors a certain amount
of dollars over time. What they neglect to say is that their approach to
indexing, accepting average returns, is at least twice as expensive and
significantly less tax-efficient than newer, more sophisticated ETF
offerings. More information on
this approach in a future article.
6. Finally, in this brief listing, remember: You have certain rights as a
customer. This is your money. Do
not be afraid to ask these questions. If you meet with avoidance or ignorance
… move on. And a second
opinion from a CERTIFIED FINANCIAL PLANNER*, professional for a modest fee
might be in order.
In conclusion, there are a number of steps you can take to
protect yourself in the investment markets. Knowledge is power.
I trust that this bit of knowledge will help in your quest.
J. Michael Fay, CFP(tm) teaches free courses about
investments through the Claremont Adult School. The next class is a series of four sessions, January
8,15,22,29.
The class is called “Seven Steps to Retirement
Success” and it covers important strategies for maintaining wealth
throughout a lifetime. It also helps people to ask the right kinds of questions
when searching for an objective financial planner. Located at the Joslyn Center
660 N. Mountain Ave Claremont, 91711.
Please call his office for more Information — (909) 624-9200.
Claremont Financial Group, Inc.
464 N. Indian Hill Blvd
Claremont, CA
91711
Securities offered through Associated Securities Corp.