Amid scandals, why buy mutual funds?

Your Funds

Dollars & Sense

November 02, 2003|By CHARLES JAFFE

Pete is angry.

"WHY," he writes in an e-mail, (his all-capitals style being the typed equivalent of shouting) "SHOULD I INVEST IN FUNDS WHEN YOU CAN'T TRUST ANY OF THESE (EXPLETIVES DELETED)."

It's a common reaction these days as one fund firm after another is tagged by scandals that center on executives breaking rules to give favored customers benefits that ordinary investors couldn't get.

Pete's question is a good one. With Janus, Strong, Nations Funds, One Group, Alger, Alliance Capital and Putnam Investment already named by regulators, investors have good reason to be disgusted and discouraged.

But should they stop investing in funds? The answer starts with a personal question: How much faith do you have in your ability to invest without funds? Mutual funds are designed to provide skilled management and diversification at a reasonable cost. Features such as automatic investment programs allow funds to also provide convenience and discipline.

Pete sent a missive, and did not respond when I invited him to discuss the situation, but he's got no reason to invest in funds if he trusts himself to replace what funds provide.

For most people, the salient features of mutual funds are hard to replicate on their own.

Experts who study investor psychology say individual investors tend to speculate more in stocks than do fund managers, giving them more potential to blow up a portfolio.

To avoid that, investors might mix and match strategies, using funds to provide diversification and stability while building a manageable portfolio of stocks and other securities. Further, using exchange-traded funds, which function like index funds but trade like stocks, an investor can achieve the wide spread of assets and reasonable cost (plus tax efficiency) without actually investing in traditional funds.

But going it alone isn't always possible. If avoiding funds means forgoing the opportunity to save in a retirement plan, the savings opportunity being sacrificed would be too great for the average investor - and many investors just don't want the challenge.

Investors who are upset, but not yet to Pete's level of shouting, should ask a slightly different question that goes something like "Which fund companies can I trust?"

New York Attorney General Eliot Spitzer warned that dozens of funds could be breaching their fiduciary responsibility to shareholders. While that means there are more errors yet to be exposed, it also means hundreds of companies operate to high ethical standards.

Selecting funds that are likely to remain above the fray is complex.

Interestingly enough, however, the things an investor should be looking for are not much different from what knowledgeable investors have always sought in funds.

Even Pete might be able to trust a fund if he can find the following:

A surprising lack of greed.

Fund companies with low fees still earn high profits, but they aren't being greedy about it. Keep annual expenses at or below these levels: 1 percent on large- and mid-cap stocks; 1.25 percent on small caps; 1.5 percent on foreign stocks and 0.75 percent on investment-grade bonds.

An alliance with shareholders.

Just 2.5 percent of all mutual funds have performance fees that slide up or down based on performance. While that kind of fee system would be ideal, in its absence an investor might look for funds where managers are part of the clientele.

A fund's "statement of additional information" - technically Part II of a prospectus, though something you'll only receive from a fund by looking on its Web site or calling to request it - lists everyone who holds at least 5 percent of a fund's shares. Short of a statement from the fund manager saying, "All of my money is in my fund," this information is as good as it gets.

A history of putting investors first.

In general, investors benefit when fund companies shutter funds that are growing too fast, and are willing to turn away money when growth might compromise the manager's ability to keep performance rolling. When a fund firm has a history of letting its winners roll until they become losers, that's a problem.

Barriers to bad guys.

The scandals generally revolve around rapid-fire trades. Fund firms that impose short-term redemption fees or that limit the number of round-trip trades an investor can make are holding costs down and aligning the interests of all shareholders.

They speak your language.

There's something to be said for companies that take the time and effort to have management tell you what's going on - in cautious tones, rather than bragging blather - or that have telephone representatives who go out of their way to answer your questions and allay your fears.

None of those characteristics talk about performance.

But in a world where many investors feel Pete's pain, investing in a fund is about a lot more than how well a fund has performed lately.

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