Answers provided in crises often are the wrong ones

Your Funds

October 12, 2003|By CHARLES JAFFE

IN ANY CRISIS, the first thing people want is answers.

The first answers they get are often wrong.

So it has been with the scandals ripping through the fund industry. This month, Alliance Capital Management officially was drawn into the murky world of funds alleged to have given preferential treatment to big investors. The firm suspended two employees - one the respected manager of its technology fund - for behavior that represented a conflict of interest.

To be sure, many more indiscretions are yet to be uncovered and acknowledged.

But while investors watch and wonder what's next, they are being inundated with financial advice, much of it dreadful, about how to avoid being caught in whichever fund is next.

"Everyone's trying to be the average Joe's champion and is jumping on the bandwagon by making a big stink about what to do," says Rueben Gregg Brewer, director of mutual fund research at the Value Line Mutual Fund Survey. "But the real big stink may be the advice that's being given, especially considering that we're probably just scratching the surface of these problems, and that we have a lot more to learn."

Here are some of the bad ideas being floated:

You can avoid trouble by investing in small fund companies.

This theory has been espoused by some journalists and on some chat boards based on the "evidence" that the investigation led by New York Attorney General Eliot Spitzer and subsequent subpoenas issued by Spitzer and the Securities and Exchange Commission has focused on big-name firms.

That hardly means small companies are immune.

In fact, you could make an argument that smaller firms might have been better targets, more easily influenced by the promise of big bucks from a hedge fund in exchange for looking the other way while some trades are made. Thinking that tiny funds or firms with small assets are immune from possible shenanigans is dumb.

To see who allowed market-timing trades, look for high turnover.

Part of Spitzer's investigation centers on funds that had rules to prohibit market timing but that allowed preferred clients to make rapid-fire trades.

You would think that taking in - and then disgorging - big chunks of cash would pump up a fund's "turnover," or how often it rolls over the securities it holds. But the trades involved in these schemes are so fast that most of the money involved never gets put to work. What's more, the formula used to calculate turnover tends to be off the mark whenever a fund gets a big inflow of cash.

If you want to spot funds where the market-timing trades are going on, look at gross sales and redemptions. You'd have a contender when you found a fund with big inflows and outflows, but stable average assets.

The trouble is, you can't get that information; most fund directors - and even fund managers - aren't privy to those flow numbers on a regular basis.

Managers who invest in their own funds would never allow this to happen.

It's always attractive to invest with a manager who has some skin in the game, some of his own cash invested along with yours. But to assume that backroom dealings that break a fund's rules can't happen just because a manager is invested with the fund would be wrong.

Most of the activities under review aren't on the manager's watch; managers run a fund's portfolio, they don't enforce its rules for shareholders.

It's always great when a manager's interests are aligned with your own. Some firms, like Longleaf Partners, make that a cornerstone philosophy for all employees. But most firms don't tell you whether a manager has thrown in on their own fund, and you can't assume a fund is clean because the manager has some of his own cash in it.

Wait to invest in funds again until the government and the SEC make rules to stop the trauma.

The funds involved had rules that would have prevented these problems, but employees broke those rules. New regulations won't necessarily change that, any more than an awareness of the Ten Commandments - rules for how people should live - stops some people from lying, stealing or cheating.

Worse yet, at a time when investors are looking hard at the fees they are being charged for investing, new regulations may result in new layers of costs, and those expenses will be borne by shareholders.

"This is a bad situation and there is no quick fix," Brewer says, "so what investors need to do is tune out the crazy ideas and keep it simple. There's just not enough information out there for people to think they can act now based on what's going to happen to funds next."

Chuck Jaffe is senior columnist for CBS Marketwatch. He can be reached at jaffe@marketwatch.com or Box 70, Cohasset, Mass. 02025-0070.

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