Mutual Fund Scandal Casts Shadow

New York Attorney General Eliot Spitzer discusses a fraud settlement involving illegal trading between Canary Capital Partners LLC and several large mutual fund companies Wednesday, Sept. 3, 2003 in New York. Canary, a multimillion dollar hedge fund, agreed to pay $40 million to settle charges that it engaged in illegal trading with the mutual fund companies, potentially costing investors billions of dollars. AP

The still-spreading scandal over shady dealings in the mutual funds industry isn't likely to hurt their overall popularity with individual investors. But it could lead to some of the biggest players in the business getting even bigger, as the funds most damaged by the charges struggle to survive.

Despite allegations that some firms allowed trading practices that shortchanged long-term investors, financial planners and advisers say mutual funds remain the best investment for most people.

Still, for small investors burned by the bear market, the charges raise new concerns as they do their year-end reviews of where they have their money now, and where they want it to be in 2004.

"Now, in addition to the normal risk of investing in the market, there's the risk that the person that you've entrusted with your money is picking your pocket," said Mercer Bullard, former assistant chief counsel at the Securities and Exchange Commission, who heads the fund shareholder advocacy group Fund Democracy. "The scandal has brought home what has always been true, and that is that you must choose carefully."

There are about 8,200 mutual funds on the market, holding some $7 trillion in assets, the combined nest egg of an estimated 95 million investors. As more people move into stocks as the market continues to improve, their stake in mutual funds is expected to rise.

At least some of the firms being eyed by state and federal investigators might not make it through 2004, however. Strong Financial Corp. recently confirmed that it is for sale, and other companies could have a tough road ahead. Fund tracker Morningstar Inc. has advised investors to sell their fund holdings in Strong and other companies charged with wrongdoing, including Janus Capital Group, Bank of America's Nations Funds and Bank One Corp.

For most investors, mutual funds remain the most effective way to build a diversified portfolio, said Kunal Kapoor, associate director of fund analysis at Morningstar Inc.

"Prior to the scandal, I think people were overestimating how clean the industry was, and now they may be overestimating how bad it is," Kapoor said. "Usually the truth is somewhere in the middle."

Firms untarnished by the scandal, such as American Funds, Vanguard Group, T. Rowe Price and Fidelity Investments, stand to gain as investors seek out trusted names. Data gathered by Morningstar indicates money is already flowing to these companies.

Smaller groups could benefit, too, said Phil Edwards, managing director of funds research at Standard & Poor's Corp. People may gravitate toward smaller firms where the owners are more likely to be investors themselves.

One good outcome of the scandal could be that it leads to greater transparency for investors, market watchers say. Regulators and lawmakers are considering reforms that would require fund companies to disclose more information about their holdings and expenses, and how they use customer fees. But firms that really want to win back investor trust won't wait for a congressional mandate, Edwards said.

"Hopefully this will create an environment where investors will push back a little bit and ask a few more questions before they jump into the pond," Edwards said. "You can't make the same assumptions you made in the past. Just because it's a good brand name doesn't mean it's a good brand."

For investors uncertain about whether they've put their money in the right place, there are a few key questions to ask. You can find out whether your fund imposes redemption fees to deter short-term trading, and whether it uses fair-value pricing, which updates the value of foreign stock to prevent market timers from making profits across time zones. You can also check out the portfolio manager's resume, see how they're compensated, and whether they hold a stake in the fund.

"A little bit of digging can tell you if you're where you want to be," said Kapoor, of Morningstar. "There are ways to make sure a fund family is truly putting you ahead of everybody else."

There are also other options, such as exchange-traded funds, which track indexes, or separately managed funds — customized portfolios overseen by professional managers, said Andrew Clark, senior research analyst at Lipper Inc. Mutual funds continue to draw many investors, though they tend to make conservative choices, he said.

"It's a hearts and minds issue, basically," Clark said. "If you feel or think you can't do business with a firm because of what they've done, then don't. However, if you feel you can, but you have qualms, evaluate them as you would any other investment ... and hopefully you won't get burned."
  • Joel Arak

Comments