Inattention could cost you a bundle

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Last week’s allegations of illegal trading practices at some of the nation’s biggest mutual fund companies have led investors to question the value of investing in mutual funds. Experts say there are a handful of alternative investment vehicles, but caution against abandoning mutual funds forever.

Last week, New York State Attorney General Eliot Spitzer announced a $40 million settlement with a New Jersey hedge fund, Canary Capital Partners, which allegedly received preferential treatment from a handful of big mutual fund firms and engaged in fraudulent after-market trading activity that may have cost individual investors billions of dollars.

Spitzer’s complaint named four major fund companies: Bank of America’s Nations Funds, Bank One, Janus Capital Group and privately-held Strong Capital Management. Two of these firms — Nations Funds and Janus — have since offered to make amends to shareholders, promising to return any ill-gotten gains, but investors are now questioning the integrity of the mutual fund industry, which has remained relatively scandal free until now, and they are asking if alternatives investments are worth a look.

Financial experts say there are suitable alternatives. These include exchange traded funds, or ETFs — essentially, mutual funds that trade like stocks. They also counsel investors to demand more shareholder-friendly policies from their fund companies, and while they say the latest investing scandal should persuade investors to view mutual funds with more skepticism, they caution against giving up fund investing altogether.

“It’s too early to assume the whole industry is tainted,” remarked Phil Edwards, managing director for mutual fund research at Standard & Poor’s. “These charges are serious and corrective action needs to be taken, but it’s too early to run for the exits. We need to wait and see how widespread all this is.”

Given their ease of use, diversification capabilities and liquidity, mutual funds have been the most popular way for smaller investors to get into the stock market in recent years. A mutual fund is a pool of assets gathered from thousands of small-time investors and used by a fund manager to invest in a wide range of individual stocks.

According to the Investment Company Institute (ICI), a national association of the mutual fund industry, some 95 million individual U.S. shareholders — or 50 percent of American households — now own at least one mutual fund. And as of July 2003, $6.9 trillion was invested in mutual funds, the ICI said, up from $2.1 trillion 10 years ago.

The popularity of mutual funds makes the schemes brought to light by Spitzer all the more unpleasant according to Jason Greene, a professor of finance at Georgia State University’s Robinson College of Business.

“Investors thought that one place where their money would be safe was in a mutual fund,” said Greene. “Most realized they would never have enough money or information to compete with institutional traders, so they thought they’d put their money in the hands of professionals, but some of them appear to have been doing shady deals with hedge funds.”

Buy-and-hold strategy

Indeed, as more and more individual investors have entered the stock market, financial professionals have advised a “buy-and-hold” strategy. Buy stocks and hold on to them through the market’s up and downs, they counseled, and you will make more from your investments than in any other asset class.

Mutual funds are widely seen as safe purchase for buy-and-hold investors. But the Spitzer complaint shows that fund managers conspired in two activities — late trading and market timing — that made a fast buck from those following this long-term strategy.

The former is the most egregious, fund watchers say.

Fund companies allegedly allowed Canary Capital, a hedge fund, to buy or sell a fund after the market has closed, but at that day’s price. Normally, investors buying a fund after the close are required to pay the following day’s price. Canary’s trades often followed news events that were likely to move the fund’s price in the next session.

The strategy hurts long-term investors because it allows short-term traders to take profits that would have otherwise gone to the fund’s buy-and-hold investors. One research study has found the strategy earns short-term investors 30 percent above the return for long-term investors.

Similarly, market timing allows savvy traders to profit from the time difference between a fund’s closing price on the U.S. markets and foreign exchanges. This strategy, which is discouraged by many mutual fund companies, can glean profits totaling more than $1 billion annually, earned at the expense of buy-and-hold shareholders according to Georgia State’s Greene.

International funds, which hold 13.2 percent of all U.S. mutual fund investments, are especially prone to this strategy, and Greene advises against investing in them. “You won’t give up too much diversification if you avoid international funds,” he said, adding that a good, low-cost alternative is an exchange traded fund, or an ETF.

An ETF closely resembles a mutual fund. It trades just like any other company on a stock exchange and tracks the performance of an index, but unlike a fund, which has net asset value, or price, that is calculated at the end of each trading day, an ETF’s price changes throughout the day from buying and selling, making it immune from market timing.

Popular ETFs include the Standard & Poor’s Depository Receipts, also called “Spiders,” which represent ownership in the S&P 500 Index.

Shareholder-friendly policies

For those investors who feel wronged by the mutual fund scandal, another strategy is to demand more shareholder-friendly policies from the fund companies you invest with, fund experts say, such as more material guidelines to ward against market timers. Fund firms like Vanguard Group and Fidelity Investments have already distinguished themselves in this regard.

“Find out how good the policing is at you mutual fund and how stringent the fund is when it comes to frequent trading,” advised K. Geert Rouwenhorst, a finance professor at the Yale School of Management. Another option, he notes, is to invest in funds that penalize frequent trading by market timers with redemption fees — essentially a fine of up to 2 percent or more for leaving a fund before a set period.

“You can go in, but you can’t leave the party too early or you’ll have to pay the price of admittance,” Rouwenhorst explained, noting that redemption fees phase out after a few months, and so pose little discomfort to longer-term investors.

Investing in a “load” fund that charges a sales fee for its shares may discourage short-term traders, Rouwenhorst said. Another option, he added, is to look for fund companies where the managers are also fund investors, and so have goals aligned with those of the shareholders. Investors may also opt to build their own diversified portfolio of stocks, but few have the time and the money to pursue such an option, he noted.

But in the end, investors may do best by holding firm on their investment strategy. Stephen Barnes, an independent investment advisor in Phoenix, advocates the widely-held view that buy-and-hold investing works best in the long run, as does the risk diversification offered by a mutual fund.

“There’s a reasonable rationale for changing your investment plan if the fund group you own shares with becomes part of this investigation, and if that’s the case voting with your feet is probably best,” Barnes said. “But there’s nothing inherently wrong with the mutual fund product. It’s just that people were taking advantage of a loophole to game the system.”