See-through Investing

New rules will give clearer view of cost of owning a mutual fund

Your Money

May 09, 2004|By Andrew Leckey

Can you see inside your mutual fund?

For decades, the mutual fund was the ultimate vehicle of trust for the average investor because it was easy to invest in, easy to follow and easy to sell.

The scandal that exploded last fall revealed we weren't fully aware of what was going on within this $7.5 trillion industry.

Yes, mutual funds are viable investments offering professional management and diversification for modest sums of money, but there's been an outlaw element.

Privileged investors and portfolio managers were often permitted to rapidly trade in and out of funds (in what's known as market timing) or trade after the market had closed; boards of directors weren't watchdogs; fees were obscure and often exorbitant; compensation practices for managers went unexplained; and deals were cut between funds and brokerages.

It's a time of self-evaluation for all fund companies, including those not charged with offenses -- the majority. The offending fund families have fired executives and portfolio managers and agreed to large settlements with the government and investors.

They've seen fund shares dumped by pension funds and individual investors.

Disgruntled investors understandably wonder whether they should give up on mutual funds altogether.

The answer is no, for this scandal has prompted greater transparency and fairness.

"Fund companies are becoming much more active in keeping market timers out, fairly valuing securities and improving compliance and disclosure," said Russel Kinnel, director of fund analysis for Morningstar Inc. in Chicago. "They're also getting better at policing this."

Some have banned the use of "soft dollars," or kickbacks in which a fund company pays a brokerage more than required to execute a trade and the brokerage responds by providing research, IPO access or information terminals.

The Securities and Exchange Commission also has a proposal under review to ban the practice, Kinnel noted.

A number of the SEC's new fund requirements are in place. As of this month, mutual fund portfolio holdings must be reported to the SEC quarterly, rather than semiannually, and in December firms must say whether they release information to anyone else between reports. All company annual reports must state fees paid over the past year based on a $10,000 investment.

"We're requiring that all mutual funds, effective in October, have a chief compliance officer responsible for overseeing compliance with federal securities laws so there aren't the abuses we've seen recently," said Paul Roye, director of the investment management division of the SEC. "Starting in December, firms must detail in prospectuses their policies to stop market timing, when they apply and for whom they are waived."

That's a start, but pay attention to the following proposals the SEC will be reviewing.

A requirement that funds charge a redemption fee on shares sold within five days of purchase, in order to deter market timing.

A code of ethics, including managers' personal accounts.

Identification of members of team-managed funds.

A listing of other funds run by a fund's managers.

A listing of the fund manager's pay schedule.

Disclosure of ownership of the fund.

An independent chairman for each fund.

Support staffs for the independent directors.

Disclosure of incentives given to sell funds.

An explanation of why the firm thinks its fees are reasonable.

Let's hope most of the proposals are enacted. Whatever the outcome, it's up to you to determine which of your funds are keepers. "Investors must look closely at the company they've invested with to see if their fund was involved in the troubles, what it actually did, how this affected performance or fees and whether it's likely to make money for them in the future," said Michelle Smith, managing director of the Mutual Fund Education Alliance (www.mfea. com) trade association in Kansas City, Mo. "You may be able to sit tight and wait as changes are made, restitution is implemented and new management takes over." "Investors have short memories that preserve the good and forget the bad," said John Keil, vice president of global fiduciary review for Lipper Analytical Services in Denver. "After this difficult time, most will realize mutual funds are good investments based on cost and convenience, but that their selection process must become much more refined."

Andrew Leckey is a Tribune Media Services columnist. E-mail him at

Checking up on your investment

Michelle Smith of the Mutual Fund Education Alliance advises giving each fund you own or are considering the once-over:

* Scrutinize performance since inception and over one, three, five and 10 years.

* Look at similar types of funds so you're comparing apples to apples.

* Make sure the investment style matches your goals and fits in your portfolio. Are you aggressive? Do you want value? The objective, the kind of securities it invests in and its fee schedule must be up front in the fund prospectus. Read it carefully.

* Determine whether you can make the minimum investment and whether the fund permits automatic monthly investments.

* Are you willing to pay a sales charge? If not, go with a no-load (no sales charge) fund.

* Does the fund family have many investment choices that will permit you to diversify your holdings?

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