Mutual-fund investors hang tough amid scandal

PERSONAL FINANCE

November 16, 2003|By EILEEN AMBROSE

IT TAKES A LOT to motivate small investors to dump their mutual funds.

The fund industry has done a good job of convincing people that funds are for the long run, and investors are loathe to pull out and perhaps pay a redemption fee without a compelling reason, such as abysmal performance, said Robert Adler, president of AMG Data Services, which tracks money flowing in and out of funds.

Regulators' investigation into market timing and illegal late-trading at mutual fund companies - activities that hurt long-term shareholders - hasn't caused an exodus by small investors. Though some fund companies linked to the widening scandal have lost investor dollars, the amount still represents a small percentage of their total assets, Adler said.

In October, the first full month since the scandal erupted, investors poured $24.5 billion into stock funds, the largest amount since March 2002, AMG reported.

"Investors are anything but complacent," Adler added. "Even though they are leaving money in, they are watching what is happening."

A recent poll shows mutual fund investors ready to bolt if problems hit home. One in five investors said they would definitely sell their shares if their fund company became a target in the investigation, according to a CNN/USA Today /Gallup poll. A little more than half said they would probably sell.

But where could they go? Mutual funds have become the easy, low-cost way for small investors to get diversification and the help of a professional money manager.

"Mutual funds and investors aren't going to be parting ways soon," said John Bacci, a financial planner with Foundation Financial Advisors in Linthicum.

Still, small investors have other options, including:

Individual stocks. The frequent allegation in the fund investigation is market timing. A trader jumps in and out of a fund - in violation of the fund's own rules - to take advantage of price movements. The trader skims off some of the profits that would have gone to long-term investors and his transaction costs are picked up by all the fund's investors.

Not a worry if you own individual stocks. Also, with individual stocks, there's more control over taxes because investors decide when to sell shares and realize capital gains or losses. Mutual funds must pass on capital gains to investors annually, whether they sold shares or not.

It takes about 20 stocks in a variety of sectors to make a diversified portfolio, said James Angel, an associate professor of finance for Georgetown University. Thanks to technology, building a portfolio is now easier and less expensive, he said.

Online brokerages, such as ShareBuilder and Foliofn, allow small investors to build portfolios of dozens of individual stocks, Angel said.

With Foliofn, for example, investors can buy a prepackaged basket of stocks or create a portfolio of up to 50 stocks. The monthly fee for a single portfolio is $19.95 and includes 200 trades.

The problem, as the bear market revealed, is that individuals often don't have the time, expertise or emotional stamina to be good stock pickers.

"People tend to overreact to individual stocks," Bacci said. "People want to buy more of what's going up and sell what's going down, which generally is the wrong thing to do."

Separately managed accounts. Don't trust your own skills at crafting a portfolio? Under this option, a professional selects securities based on your goals and manages the account.

"The benefits are presumably it fits you better and, since you own the individual investments, you ought to have better control over the tax consequences," said Chuck Carlson, chief executive of Horizon Investment Services in Hammond, Ind.

These accounts used to be for the very wealthy. Still, they're not cheap. The minimum investment can be $50,000 to $100,000, and annual fees range from 1 percent to 2.5 percent, Carlson said.

Exchange-traded funds. ETFs are like index funds that can be traded like stocks throughout the day. Shares of open-ended mutual funds can be bought or sold once a day.

ETFs have low fees. They are tax-efficient. Because they track an index, they aren't constantly adding and dropping stocks and potentially generating taxable gains for investors.

"The only way to get capital gains is when you sell the investment itself for more than you purchased it," said Denise Leish, a money manager with Money Plans in Silver Spring.

Leish said she hasn't used mutual funds for a couple of years since switching to ETFs. "There's an ETF that represents every index you can think of and every sector you can think of," she said.

One drawback is that you must pay a commission each time you buy or sell ETFs, which gets pricey for small investors who invest a little each month.

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