Surviving the Fund Scandal

For a nation invested in mutual funds, these are the proverbial best and worst of times. Last year, the typical stock fund racked up an impressive gain for the first time since the market sold off in earnest in March 2000. On the other hand -- and that would be the one that slaps you silly -- the industry's soft underbelly got positively gigged when New York Attorney General Eliot Spitzer uncorked the sorry successor to 2002's Wall Street scandals.

A year in review
According to Spitzer's office, fund shops operated by the likes of Bank of America (NYSE: BAC  ) , Bank One (NYSE: ONE  ) , and Janus Capital Group (NYSE: JNS  ) permitted certain big-shot investors to trade rapidly into and out of their funds, essentially funneling gains from long-term investors to traders. Worse, Spitzer alleged that Bank of America's Nations Funds unit actually facilitated trades after the market close.

Already, more than a dozen other fund shops have been implicated, including Alliance Capital (NYSE: AC  ) , Federated Investors (NYSE: FII  ) , FleetBoston Financial (NYSE: FBF  ) , and Marsh & McLennan Companies' (NYSE: MMC  ) Putnam unit. Almost overnight, the mutual fund industry's squeaky-clean image was left in tatters. In its place, we have an image of craven corporate bean counters in pursuit of quick and ill-gotten profits.

Sorry for the overheated language, but it sure beats we told you so. For years, The Motley Fool has advised against owning mutual funds, and now, more than ever, we see why. Our advice has long been that folks willing to do their homework are better off investing either in individual stocks or in low-cost index-trackers such as Vanguard 500 IndexFund (VFINX).

Sing a new song
Still, it always nagged me that maybe we were painting the entire industry with too broad a brush, and that maybe -- given that so many people are invested in funds -- we might direct our attention to identifying the best among an admittedly middling lot. We launched Motley Fool Champion Funds with just that in mind -- and with the goal of helping investors steer clear of the junk and home in on those with a history of doing the right things and beating the S&P 500 in the process.

But while that's all well and good for the future, what, pray tell, should savvy fund investors do now? Good question.

First, if you hold funds from families that have been implicated in the scandal, don't assume you should sell your shares posthaste. Among other considerations, any decision to unload a fund must be made in light of the tax hit you're likely to take. Righteous indignation notwithstanding, there's no reason to add insult to injury by selling a fund from a shop that has violated your trust and then sending a check to Uncle Sam for the privilege.

Remember: Despite the damage to the reputations of the implicated shops, the funds themselves aren't going to hit the skids as a result of the scandal. Regardless of the revelations, their Net Asset Values (NAVs) are still going to be determined by the value of the stocks held in their portfolios.

The good news?
So sit back, relax, and enjoy one of the advantages of being a fund investor. Unlike shareholders in scandal-ridden corporations like Enron (OTC: ENRNQ) and WorldCom, you aren't going to lose your shirt thanks to the antics of a few jokers who were more interested in lining their own pockets than doing right by their shareholders. Mutual funds don't work that way, which is one of the main reasons so many people invest in them.

In fact, I'm encouraged by the way the scandal has played out so far. The settlement terms that some of the implicated shops have agreed to are huge, and I absolutely love the fact that Spitzer has been negotiating fee-reduction programs with some shops along the way.

And after years of behaving like toothless watchdogs, federal regulators are finally getting in on the action, helping to push the industry toward some serious (and long overdue) reforms. Mandatory redemption fees (which would defeat the purpose of rapid trading) are on the table. The infamous 12b-1 fee (a marketing surcharge that many funds bake into their expenses) is coming under scrutiny, too. And beginning later this year, funds companies must disclose in dollars and cents the costs associated with a $1,000 investment in every fund they offer.

Stop that check!
All of that said, not selling a fund from a scandal-tainted shop is one thing. Sending even one more dollar to that firm is quite another. Until the culprits have proved over time that they've cleaned house and changed their ways, there's absolutely no reason to send them another dime. Plenty of shops haven't been accused of wrong doing, so plan to do your next round of mutual fund shopping there.

What's more, even if you don't hold funds from any of the firms implicated thus far, you should still plan to stay vigilant. Spitzer's probe is ongoing. And beyond putting you on the look out for criminal or unethical behavior, the scandal should be your cue to take a cold, hard look at each fund you own and ask the following questions:

  • Is it pricey? (The typical actively managed stock fund's expense ratio will ding you about 1.5%.)

  • Does the manager churn through stocks like your kid goes through Xbox games?

  • How long has that guy been at the controls anyway?

  • Does he put his money where his mouth is by investing his own moolah in the fund? (If not, why should you?)

  • What's the fund's performance been like over the long haul? Would you have done just as well (if not better) in a low-cost S&P tracker?

That's not an exhaustive list, but it's a very solid start. And surprise, surprise: We ask each and every one of these questions as we go about the business of picking funds that make the grade in our Champion Funds newsletter.

Quite the coincidence, huh?

Shannon Zimmerman is a Fool for funds and editor ofMotley Fool Champion Funds, but he doesn't own shares of Vanguard 500 Index. You can ask him why via email. The Motley Fool is investors writing for investors.


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