Swear Off Funds Forever?

This week, New York Attorney General Eliot Spitzer announced a $40 million settlement with a hedge fund that allegedly received favorable treatment from some big mutual fund companies, at great expense to fund shareholders.

The complaint filed by Spitzer's office alleges that Edward J. Stern, who manages the Canary Capital Partners hedge fund, promised to make substantial investments in several mutual funds in exchange for the ability to improperly trade fund shares, in some cases after the market had closed.

The funds cited in the complaint -- which have not yet been charged with any crimes, though investigations are ongoing -- are operated by Banc One (NYSE: ONE  ) , Janus Capital Group (NYSE: JNS  ) , Bank of America's (NYSE: BAC  ) , and privately held Strong Capital Management.

It's just the latest in a long list of revelations that leave investors questioning the integrity of the people who run mutual funds and those who sell them. Among the most recent developments:

• Congress and the Securities and Exchange Commission are investigating whether fund companies aren't revealing the actual amount of expenses shareholders pay. John Bogle, founder of the Vanguard family of mutual funds, estimates that a fund's expense ratio might account for as little as half of the true costs of investing in a fund.
  
  
• Spitzer, Massachusetts Secretary of the Commonwealth Bill Galvin, and the SEC are looking into whether Morgan Stanley (NYSE: MWD  ) induced its brokers to sell the company's funds rather than third-party funds, which may have been better for their clients. Galvin is also investigating Prudential (NYSE: PRU  ) .
  
  
• The National Association of Securities Dealers, the self-policing organization of the brokerage industry, has found that many brokers did not give their clients appropriate "breakpoints," which are discounts on commissions for large investments in mutual funds.
  
  
• The SEC and the NASD have been looking into the overselling of Class B shares of mutual funds, which can be the most expensive type of shares under many circumstances.
  
  
• The performance of equity mutual funds over the past few years has been horrific. According to Standard & Poor's, the majority of actively managed funds have not outperformed their respective S&P indexes over the trailing three- and five-year periods. Despite this underperformance, fees charged by fund companies have actually risen over the years.

The arguments for no-load (i.e., no commission) index funds or exchange-traded funds (ETFs) bought from a discount broker have never been stronger. Choose this strategy, and you'll do far better than the typical investor who uses a full-service broker and invests in actively managed funds with high sales commissions.

It's not that all brokers are evil. If you work with one, and he has earned your trust as well as market-beating returns after fees and taxes, then stick with him. But big commissions and asset-based compensation have impaired the integrity of many brokers and fund managers and directors. Choosing an index-based investment, which will certainly cost you less and probably make you more money, seems the safest move when fishing in Wall Street's murky waters.

Peruse our 60-Second Guides to learn about index investing, ETFs, and opening a discount broker account. And visit our Advisor Center to determine if you're getting the best financial help.