The recent mutual fund scandals have shown how certain industry insiders put their own interests first, at the expense of customers who trusted them. Should investors trust the industry again?
To paraphrase the 18th century Irish statesman John Philpot Curran, eternal vigilance is the price of a good investment. Or, to put it in more modern terms, trust but verify. Mutual funds remain an excellent way for most investors to build diversified portfolios at reasonable cost. But you want to find funds that demonstrate, through reasonable fees and steady, principled management, that shareholders’ interests take priority. Those fund companies have, at least so far, been resistant to the stain of scandal.
In September 2003, New York Attorney General Eliot Spitzer alleged in a complaint against a small hedge fund that four major mutual fund companies had allowed favored investors to profit from short-term trading at the expense of other fund investors. Other allegations, involving more fund companies and management, quickly followed.
The costs for the fund companies involved and the mutual fund industry have been staggering (see “Mutual Fund Scorecard” on our Web site at www.palisadeshudson.com). As this article is written, more than 20 fund companies, banks and broker-dealers have paid nearly $3 billion in settlements. Eleven company executives have personally paid more than $220 million in fines and have been barred from the securities industry for periods ranging from six months to life. At least 12 other executives have resigned or been fired. In response to the scandals, the U.S. Securities and Exchange Commission has introduced or proposed more than a dozen industry reform rules.
Mutual fund investors indirectly paid higher expenses and suffered lower fund performance because of some of the abuses. One of the initial scandals involved market-timing trading, in which certain investors took advantage of stale mutual fund prices. Current information was not reflected in the prices of the mutual fund’s underlying securities. A short-term investor could exploit this anomaly to the detriment of long-term shareholders. Market timing is not illegal, but it was prohibited by many fund prospectuses.
According to a 2002 research paper by Eric Zitzewitz, assistant professor of strategic management at the Stanford University Graduate School of Business, regionally focused international stock funds were the most susceptible to market timing abuses. He calculated that market-timing activity cost long-term shareholders in those funds up to 1.6 percent per year between 1998 and 2001. Returns in other types of stock mutual funds also were reduced, but by smaller amounts, Zitzewitz reported.
The mutual fund industry may have learned its lesson from the high costs of dealing with the scandals. The abuses noted by Spitzer and other regulators may well have been corrected, at least for now. But that does not mean investors are home free. Fallout from the scandal, such as higher administrative costs — insurance premiums, heftier compliance obligations and legal fees — could result in higher shareholder expenses, and therefore lower returns, in the future.
What about the ongoing cost to investor confidence? Many investors may understandably wonder why they should bother investing at all, or if they do, why use mutual funds? After all, just when their confidence may have been recovering from the Enrons and Worldcoms of the world, dishonest mutual fund companies sideswiped them.
It makes sense to reflect on how, and with whom, we invest our hard-earned dollars. For most of us to meet our financial goals, we must invest our resources according to a well-thought-out strategy. Mutual funds have many advantages over other investment vehicles in implementing such a strategy. They can offer inexpensive diversification of investment risk and easy access to professional portfolio management.
The scandals have reinforced to investors the importance of judging whom they can trust. How can investors avoid the next “shady” fund? While there are no guarantees, carefully crafting and monitoring your fund selection criteria can help steer you toward trustworthy companies and away from questionable ones.
At Palisades Hudson Asset Management, Inc., we have no special insights into the operation of fund companies, but our preference for low-cost, reputable fund families with a straightforward approach to running funds has led us to companies such as Vanguard and T. Rowe Price — companies thus far not implicated in the scandals. An individual fund’s investment strategy must fit our clients’ objectives, and we like to see long-tenured fund managers who consistently follow that strategy. By monitoring the funds, we can identify concerns and make decisions based on what we learn. When you consistently try to work only with ethical people, odds are you find those you can trust.
