Experts advise dumping funds tinged by scandal


October 12, 2003|By EILEEN AMBROSE

FOR DECADES, small investors saving for college and retirement through mutual funds could take some comfort knowing that the fund industry had avoided the kind of scandals that periodically erupt on Wall Street.

That's now changed. Last month, New York Attorney General Eliot Spitzer accused several fund companies of sacrificing the interests of long-term shareholders by allowing a hedge fund to make trades that either violated the law or the funds' own rules.

Spitzer's investigation is continuing, and major fund companies, including Putnam Investments, Vanguard Group, Legg Mason and Fidelity Investments, said they have received subpoenas.

Exactly how much the alleged abuses have cost shareholders is unknown. But many agree the long-term damage may be the loss of trust among small investors.

"It gets to the core of the fiduciary duty of mutual funds to act in the best interest of their shareholders," said Russ Wermers, an associate professor of finance at the University of Maryland. "You trust your fund to do the right thing for you."

So what's a mutual fund investor to do? Some experts advise selling funds whose companies are accused of violating investors' trust, while others recommend a wait-and-see approach. Many agree, though, this is a good time for investors to take a hard look at their funds and make sure there aren't other problems, such as high fees, that can be even far more damaging to their returns.

Of course, the immediate question for some investors is whether to hang onto funds of Bank of America, Bank One Corp., Janus and Strong, the companies mentioned in Spitzer's complaint against the hedge fund Canary Capital Partners.

Spitzer claims the companies violated their own rules by permitting Canary to use their funds for market timing, or jumping in-and-out of funds to take advantage of price movements. It's not illegal, but many funds discourage the practice because it disrupts their investment strategy and the transaction costs are borne by all investors in the fund.

Bank of America faces far more serious allegations of illegally allowing Canary to trade after 4 p.m., when the funds were supposed to be closed. That allowed Canary to take advantage of late-breaking information affecting share prices, and to dilute the profits of other shareholders, Spitzer claims.

All four companies promise to make restitution if investors have been hurt.

Still, the allegations are serious enough that Morningstar Inc., the fund research firm, and others suggest selling or avoiding funds of these companies.

"The reason is simple: You want to invest with someone you can trust," said Russel Kinnel, Morningstar's director of fund analysis.

Of course, the decision to sell must be weighed against the tax consequences, Kinnel said. And investors may not have a choice of selling if their 401(k) is limited to funds of these companies, he said.

Standard & Poor's recommends against selling funds until more details come out.

If you're not investing in one of these fund companies, experts advise looking for other problems that might plague your funds. Among them:

High annual fees: As consumers, we know we're being ripped off if someone charges $200 for an oil change, said Douglas Fabian, editor of the newsletter Successful Investing. But when it comes to investing, people don't pay attention to fees that eat away at returns or understand what's out of line, he said.

"Any fee over 1 percent is a high fee," said Fabian. He compiles a lemon list of underperforming funds, and often it's high fees that contribute to the poor performance, he said.

High portfolio turnover: From 1984 to 2002, the stock market gained an average of 12.2 percent a year, but the average equity fund grew 9 percent, said John Bogle, founder of the Vanguard Group and president of Bogle Financial Markets Research Center in Pennsylvania.

The difference can be partly blamed on high turnover in many stock funds, where fund managers buy and dump stocks so frequently that they rack up large trading costs and related expenses, he said.

Bogle advises sticking with low-turnover funds, which he defines as funds that sell 35 percent or less of holdings annually. For that reason, too, he recommends index funds, which have low turnover because they generally buy and hold the stocks that make up a benchmark.

Management turnover: The average fund manager sticks with a fund for five years, Bogle said. During an investment lifetime of 55 or 60 years, "think of all the managers [investors] will have," he said.

A fund manager is basically a trustee hired to invest your money, and frequent changes in managers means investors have a new personality and perhaps a whole new investing style to deal with, Bogle said. Also, new managers tend to make a clean sweep of the fund's holdings, thereby running up trading costs and generating taxes, he said.

Bogle recommends looking for a fund manager with at least 15 years of experience, preferably with the same fund.

Trendy funds: Avoid fund companies that "always bring out new funds to capture the speculative frenzy of the day," Bogle said. Those companies, he said, "are more interested in marketing than managing."

Manager's money: To assure that the fund manager's interest is closely tied to that of shareholders, Bogle advises investing with a manager that invests in his or her own fund. "Is the manager eating his own cooking?" he said.

This doesn't have to be disclosed by fund companies, although some do release the information, he said.

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at

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