Structure of mutual funds, SEC safeguards designed to protect investors' assets


January 26, 1992|By WERNER RENBERG | WERNER RENBERG,1992 Werner Renberg

"How safe are mutual funds?" asked a reader who says he has "a fair amount of money" invested with a large, well-regarded no-load fund family.

"What happens if a company 'folds'? Can that happen? Are funds which invest in government securities completely safe?"

"Help me to comfort my wife," another reader pleads. "[She] feels that because there are so many frauds and failures in the business world . . . the only safe place is in FDIC [Federal Deposit Insurance Corp.] accounts."

The concerns are understandable.

They're understandable because investing in a mutual fund, run miles away by people you'll probably never meet, is more complicated and takes more faith than, say, putting money into an FDIC-insured bank whose staff knows you.

Those concerns are especially understandable during a recession, when business failures rise, or when weakness in an economic sector such as real estate brings down major financial institutions that had seemed invincible. If savings and loan associations, banks, insurance companies, or brokers can run into trouble and even fail, can funds be safe?

The concerns reflect confusion about how mutual funds are structured and a lack of familiarity with what the Securities and Exchange Commission and fund directors do to protect investors.

Mutual funds are structured as distinct business entities, separate from the firms that form them and manage their affairs.

It's difficult to imagine a mutual fund going bankrupt -- except perhaps for a most unlikely event, such as an extremely irresponsible use of options by a portfolio manager.

On the other hand, the investment adviser managing a fund can go bankrupt or run afoul of the law, as some firms have. Its business failure or legal punishment, however, should not affect the safety of the securities and cash owned by the fund's shareholders.

By definition, a fund can't go bankrupt as long as its assets exceed its liabilities, as they always do. You see confirmation of this in this newspaper every day. It is, after all, the net asset value (NAV) per share -- the amount by which assets exceed liabilities, divided by the number of outstanding shares -- that you look at when you check on how the prices of your funds changed the previous day.

Over time, the NAV of a money market should remain constant at $1 per share, a well-managed bond fund's should remain relatively stable, and an equity fund's should grow.

This is not to suggest that bond and equity funds' NAVs don't fluctuate or that a fund's NAV can't suffer a tremendous drop. Of course, these things can and do happen.

They're the result of securities price fluctuations, sometimes compounded by high annual fund expenses. When investing in individual securities, instead of taking advantage of the diversification provided by a mutual fund's portfolio, investors are exposed to even greater investment risk.

There are no guarantees against a drop in share prices. Even when a fund is fully invested in Treasury securities, backed by the full faith and credit of the U.S. government, its NAV will fluctuate because Treasury issues are not guaranteed against falling prices. When you buy them, you're only sure you'll get interest when scheduled and principal at maturity.

Investment risk is something that portfolio managers deal with, but what about other risks to a fund's assets?

The Investment Company Act of 1940 stipulates that funds must use custodians to hold their securities. Most use banks. In case a bank fails, a fund's assets can't be touched by the bank's creditors. (A fund board may choose a custodian affiliated with the adviser, but then must have independent auditors perform occasional counts.)

The act also requires funds to obtain fidelity bonding to protect them against larceny and embezzlement by officers and employees. Every year, each fund must report to the SEC on its insurance coverage, including whether any claims were filed.

Unlike a fund, the investment adviser sponsoring it and managing its portfolio can go bankrupt. Although some have enormous assets under management and are financially strong, as the table indicates, many of the estimated 600-700 firms in the business are fairly small. (It doesn't take much capital to get started.)

An adviser's bankruptcy doesn't directly affect fund assets. But it can interfere with the proper management of a portfolio until the advisory contract is acquired by another firm.

Both fund directors and the SEC try to watch out for the deterioration of advisers' financial conditions. Every fund's directors are required to check the financial condition of its investment adviser during the annual review that precedes renewal of an advisory contract. They have to make certain the adviser is able to fulfill the contract.

The SEC monitors advisers' financial statements when it conducts inspections of fund records -- annually for the 100 largest fund complexes and less frequently for other funds.

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