Four ways to help mutual fund investors

Your Funds

Your Money

April 18, 2004|By CHARLES JAFFE

"OK, genius, what could a fund company do that would fix the disclosure problem and help people pick better mutual funds?"

I love questions like that one from a fund executive in response to a recent column, in which I suggested that reforming the fund industry would not make picking funds any easier.

Yes, investors should be pleased with changes being demanded by regulators, namely increased disclosure of fees and conflicts of interest, plus the elimination of some troublesome business arrangements.

But no investor is going to say, "Gee, now that MFS Investment Management has eliminated soft-dollar arrangements, I'll know which of its funds to buy."

Soft-dollar deals, effectively, are kickbacks, so that a fund company pays a brokerage firm, say, 5 cents per share for making trades. The brokerage firm then gives the fund management company the equivalent of a 1-cent rebate, in the form of research, data services and other items.

Firms that accept soft-dollar deals are folding in research with transaction costs, instead of into the fund's expense ratio, so the deals hide true costs while also creating an incentive to overpay for the execution of trades.

There's little doubt that investors will be better served by the elimination of soft dollars, but there's never been an individual investor whose primary decision criteria was whether a fund avoided soft-dollar transactions.

There are some moves, however, that could be a significant help to an investor making a decision on a fund:

Highlight prospectus changes, rather than hide them.

Virtually every fund company is running through prospectus changes these days, either to eliminate the problems they encountered or to make sure they won't be the next company tagged by authorities.

The average investor would have to know a prospectus by heart to find some of these changes, particularly the subtle ones.

That's why funds should take a page from the folks who print sports rule books, and put a page at the front that details the changes being made from one year to the next. What's more, all changes should be printed in a special font, and should carry an explanation for why each change is being made.

In this way, an investor can find any rules changes just by skimming the prospectus, which makes it much more difficult for a fund to bury key maneuvers in the fine print.

Assess how funds work together.

Fund companies do investors a disservice by selling them funds that have tremendous overlap. The consumer may think that they are diversifying their portfolio by diversifying into sister funds, but if the international fund and global fund, or the large-cap growth and large-cap blend funds have a lot of the same stocks, the investor can only gets faux diversification.

Fund firms can do the overlap and correlation analysis and issue a warning whenever funds are, say, one-quarter identical. The disclosure could say something like this: "This fund is significantly similar to the following funds offered by the firm, and investors who buy this issue in addition to any of the ones listed may not get the full diversification benefits normally associated with investing in multiple funds."

Disclose a fund's tax policies.

Regulators are asking firms to provide more portfolio data, as well as the manager's compensation incentives, both of which are crucial for helping an investor set realistic expectations.

But the other piece that would show how a fund fits in with a portfolio involves taxes. A fund's tax-efficiency history - which is available - doesn't necessarily predict the future, so management should say whether a fund pays attention to taxes (listing steps taken to minimize distributions) or whether taxes do not factor at all into day-to-day management decisions.

While they're at it, fund managers could say whether, as a result of these policies, a fund is better suited for a retirement or tax-advantaged account than in a taxable one, where gains will be siphoned off by Uncle Sam.

Evaluate the board and its ability to govern independently.

This is not something fund firms should do, but Morningstar, Lipper, Value Line and others could start developing a measure of a fund's board of directors.

Based on independence, quality, work load, taking action when poor performance warrants a management change, decisions on fee approvals and more, the big ratings firms could add a qualitative measure of a fund's boards.

Investors are banking on improved board independence - and so are regulators - but have no way of judging board competency. The data firms have the knowledge to develop a measure that would tell an investor, "This board is on your side."

Couple that kind of recommendation with outstanding investment management and investors would be able to pick funds more confidently.

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