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As firms tainted by the widening mutual-funds scandal see significant amounts of money yanked from their portfolios, fund experts say there could be some negative consequences for those investors left behind. But few think it’s a good idea for every fund holder to take their money and run.

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The list of U.S. fund companies hit by allegations of improper trading is growing by the day, and an increasing number of large U.S. public pension funds are voting with their feet, moving to pull billions of dollars from pension funds implicated in the widening scandal.

Six states — Pennsylvania, Iowa, Rhode Island, Massachusetts, New York and Vermont — have taken more than $4 billion in business away from Putnam Investments following allegations of improper trading at the firm, the nation’s fifth-largest manager of mutual funds. Shares of its parent, Marsh & McLennan, have dropped about 10 percent since Sept. 16, when Massachusetts regulators first said they were investigating Putnam.

The important question now for the millions of Americans who have invested $7 trillion in mutual funds is: Should they follow suit? And, more significantly, if there is a run on fund companies named as probe targets, what happens to those investors left behind?

The answer, fund experts say, is to not act hastily. Fund investors in tax-sheltered retirement accounts, such as 401(k) plans, don’t endure large tax penalties for changing funds, but switching out of funds at firms named as probe targets could still be a mistake, they say.

It’s rare for a fund to be so harmed by redemptions that it is forced to liquidate its assets and close, they note. Most also caution that although a handful of fund families are now under the regulatory spotlight, dozens more could be drawn in, so it pays to sit tight rather than move money into a new fund group only to see it implicated later on.

“When the problem was confined to firms like Janus and Bank of America, if you had jumped to Putnam, I’m not sure what sort of shape you’d be in right now,” said Phil Edwards, managing director for mutual fund research at Standard & Poor’s. “I think we need to wait to see the dust settle. But if you jump, be careful where you jump.”

Impact from redemptions
If there are large redemptions at a fund, it’s not necessarily the case that investors will be significantly impacted, according to Edwards. A fund manager should have enough cash on hand to meet the redemptions, he said, but if they rise significantly and quickly, a manager might have to liquidate a fund’s best holdings and that could harm its performance, regardless of the fund’s size.

In the unlikely event that massive redemptions force a fund to close, the fund’s assets would be converted to cash at the fund’s net asset value, or NAV, and distributed to investors, Edwards added.

“If you’re one of the last investors standing, that’s what you’d get, but it’s more likely that a fund would be merged with a larger fund that’s more stable,” said Edwards.

Large redemptions are likely to hit small- and mid-capitalization funds harder than blue chip, large-cap funds, as liquidity is limited in stocks of smaller companies, according to Tom Taulli, a finance expert and a business professor at the University of Southern California. “This is not a big problem for big-cap funds, but the liquidity issue could hurt smaller-cap funds,” he said.

Still, overall the impact on investors is likely to be limited, Edwards noted, as the amount of money leaving mutual funds is not significant at this point.

“I don’t think we’re seeing a run on the bank, but the question is will it pick up? The mitigating factor here is the stock market is rising, so people are reluctant to sell. If we were in a down market this could be a great deal worse than it is now,” he noted.

A run on a mutual fund is extremely rare and probably unprecedented, Edwards added. The closest analogy is the significant drop in assets seen in technology funds in 2000.

“There is a similarity there,” Edwards said. “Tech funds certainly saw a significant loss of assets; some were dissolved and some were merged into other funds, but the declining market took away most of their value. And even though they have been through a rough patch some of them are still going, but they’re not the size they used to be.”

Money flowing from funds
Fund experts might be telling investors to sit tight, but money appears to be flowing out of some funds all the same, although experts say the redemptions are not enormous.

Still, a rising stock market has continued to drag money into equity funds at a rapid pace.

AMG Data Services, an independent company that measures fund flows, expects about $20 billion to have poured in during the month of October — the largest monthly inflow since March 2002.

The scandal-tainted fund firms like Putnam Investments and Strong Capital Management have seen noteworthy redemptions, AMG added.

In the week ended Nov. 5, Putnam saw $3.9 billion pulled from its funds according to Robert Adler, president of AMG — the largest outflow from any fund family in 2003. And in October Strong Funds saw the largest outflow of money from its open-ended equity mutual funds so far this year, Adler noted.

“We don’t know if these are investors responding or the beginning of something much bigger,” noted Adler. “Overall, it appears the impact of the fund scandal has been negligible, but as soon as specific charges are levied against firms like Putnam, investors are certainly starting to respond,” he added.

Much of the money that has left Putnam, Strong and other funds implicated in the scandal appears to have moved into other mutual fund groups, according to Charles Biderman, founder of TrimTabs Investment Research, which also tracks fund flows. Merrill Lynch, for example, recently raised its rating on T. Rowe Price Group, saying the fund management group firm could benefit from the industry’s regulatory issues.

“Some of the fund companies implicated in this issue have seen outflows, but that money has flowed into other funds and not into people’s mattresses,” Biderman said, adding that the main reason equity funds are still popular is that stocks are the best performing investment vehicle right now.

“If all this had happened prior to March 2003, when stock prices started their dramatic comeback, there would have been a dramatically different response” in the stock market, he said. “The outflows we [could have seen] then would have intensified.”

Paybacktime?
A number of fund firms — including Bank One, Bank of America, Janus and Putnam — have promised to pay restitution to investors harmed by improper trading. But investors waiting for a check in the mail may have a long wait, noted S&P’s Edwards.

These firms are seeing class-action lawsuits brought against them and it could take years for the legal wrangling to work through to a conclusion, he said. A spokesperson for Bank of America’s Nations Funds, named in the complaint brought against hedge fund Canary Capital Partners by New York Attorney General Eliot Spitzer in September, said the firm is waiting for the results of an outside study into the financial impact of improper trading. The firm took a $1 million charge in the third quarter partly to cover repayment costs.

Spokesmen at Bank of America and Bank One said plans for paying restitution have not been finalized.

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