assessing the mutual fund scandal

 

By now almost everyone has heard about the on-going mutual fund scandal. In fact, there has been so much information reported by the financial media that it’s difficult to differentiate the real issues from the noise.

 

So, what are the issues investors should be concerned about, and what should they do?

First of all, a few definitions are in order. The regulators are concerned about two types of unacceptable behavior that individuals, hedge funds and the mutual fund families were engaged in.

 

The first is market timing which is not illegal in most cases. Because of the time-zone difference between international and U.S. stock markets, foreign funds sold in the U.S. hold stocks that are priced as of the previous day’s market close overseas. Traders, knowing that foreign markets closely track the U.S. markets, attempt to race in and out of international funds at the end of the trading day in New York in order to make a quick buck once the foreign markets open again. Many of the implicated fund companies explicitly prohibited market timing in their prospectus, even as they secretly negotiated such deals with various hedge funds and other large investors.

 

The second type of behavior is illegal. With late trading schemes, speculators essentially get to bet on the horses after the horse race. This criminal activity involves making buys or sells after the markets are closed; in effect, they were buying stocks on sale when no-one else could.

 

As of late December there are approximately 40 mutual funds from 10 fund families implicated in this scandal. That’s 40 funds out of the more than 15,000 available today, so the scandal at this point, although quite serious, is not pervasive.

 

The investors in those forty funds could have lost, by some estimates, as much as 1-2% in return because of market timing and late trading. The Wall Street Journal pointed out recently that most of the funds implicated were "growth funds," which typically have higher turnover rates and higher volatility because they are attempting to beat the market with picking and timing strategies. Growth style funds lost over 27% on average in 2002, which puts the 1-2% cost of the scandal in perspective.

 

In the end we may come to realize that this current scandal was a very cheap lesson for American investors. One of the fund companies implicated has already agreed to lower the fees they charge for mutual funds, and others may follow because of pressure from the public, the SEC and various state officials.

 

In addition, we are already seeing more independent directors added to mutual fund boards and more transparency regarding fund manager pay, conflicts of interest and soft-dollar payments to third-parties. All of these important changes to the old way of doing business will benefit investors in the long-run.

 

But what about now, you ask? What should an investor do if they have money invested in one of those 40 funds?

 

The good news is that the cost to the individual investor was not large and the value of their investment isn’t going to plunge overnight. Remember, owning a mutual fund, which is a large basket of stocks or bonds, is very different than owning the stock of that one mutual fund company. If you own a particular mutual fund, for example, you probably don’t own stock in the parent company.

 

The bad news is that the implicated fund companies will probably not be the best place to invest money for awhile. These families are seeing billions of dollars exit their funds and have lost or fired some of their top executives. There are plenty of low-cost, upstanding mutual fund companies to pick from and you should not wait to be the last shareholder out of the building.

 

It’s worth noting that all of the fund companies who have been implicated employ active money managers to oversee their funds. Maybe more investors will learn to appreciate the long-term value of passive investing using institutional asset class funds. That would be a worthwhile lesson for the mutual fund industry to learn.

 

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