Last year, it seemed that every morning the newspaper reported
some scandalous behavior associated with corporate accounting.
Remember Enron and the other related headlines? This year,
the bad news allegations have been about a handful of mutual
As an independent, professional financial advisor, I'd
like to add my voice to what will obviously be an ongoing
conversation in the weeks and months ahead. Hopefully, this
commentary will provide some insights and help you give you
a better perspective regarding what the press is calling "the
Mutual Fund Scandal."
Let's start by defining the related terms and by putting
a framework around the problems that have been unearthed.
More importantly, my commentary will also address the most
pressing question you most likely have: What does all this
mean to me as an individual investor?
Two Key Problem Areas
The current mutual fund problems fall into two broad categories:
While late trading is actually illegal, excessive trading
is not illegal. Excessive trading is, however, of dubious
ethical standing. You may also hear "excessive trading" referred
to as "market-timing" and "late trading" referred
to as "stale price arbitrage."
- Excessive trading ("market timing")
- Late trading ("stale price arbitrage")
First, let's make some distinctions about the term "market
» Calling excessive trading "market timing" may
be confusing to many investors. "Market timing" as
it pertains to a particular mutual fund company's wrongdoing
means something entirely different than what your current
understanding of the term may be.
» Normally, when financial planners talk about "market
timing" we are referring to the fact that no one can
predict with any degree of certainty the short-term ups and
downs of the securities markets. Many financial planners,
myself included, emphasize that time in the market - not
market timing - is an investor's friend. Studies
show that even the most astute investors have difficulty
timing their investment purchases and sales to meet the lofty
goal "buy low and sell high." Instead, most investors
hurt themselves by being out of the market during market
» What's involved in the mutual fund company
problems is the rapid buying & selling of fund shares
in anticipation of short-term price movements in the securities
contained in fund portfolios. This is not illegal, but such
trading may increase expenses for long-term fund shareholders,
and can violate fund company policies.
Late trading or "stale price arbitrage" involves
taking advantage of price movements after the exchange on
which the mutual fund shares are traded is officially closed.
This is (at least mostly) illegal.
Impacts to Mutual Fund Shareholders
A study by a respected industry publication, Investment
News, suggests that neither late trading nor "marketing
timing" have overtly hurt mutual fund shareholders.
While it is difficult to draw a definitive link between such
questionable trading activities and fund performance, if
we look at the performance of the fund groups implicated
we see that they compare nicely (as measured by Morningstar
ratings) to other well-respected fund companies that have
not been implicated. Theoretically, marketing timing and
late trading can lead to poor performance, but in reality
it is the underlying stocks and expense ratio of the fund
that makes the biggest difference in performance.
Let's dig a little deeper. Most Americans invest through
mutual funds. Are they still safe? How should we respond
to these scandals?
Minimal Impact. Without at all excusing this unethical behavior,
let's acknowledge that unlike the accounting and management
irregularities at companies like Enron and Worldcom, which
caused their investors substantial losses, the mutual fund
company improprieties have caused minimal loss to fund shareholders
like you or me on an individual basis. It's a little
like the old movie about a scheme to direct all the "rounding" in
a certain bank's accounts to a single account; while
fractions of a cent can really add up if you have enough
volume, for any given account the effect is really not material.
According to the Investment Company Institute, even if restitution
funds add up to one billion dollars, that would equate to
about a $20 restitution per U.S. household owning mutual
Another Argument for Index Funds. It is important to note
that most of the objectionable activities would be pointless
if investors held broadly diversified index funds. Actively
managed mutual funds are just extensions of the "hot
money" philosophy and counterintuitive to a sensible
investment approach. Active management is almost exclusively
employed in highly volatile, growth-oriented, sector-betting
funds. This highlights the need for investors to understand
not only investments, but the investment business, and associated
potential conflicts of interest. When you invest in broadly
diversified index funds, there is virtually no possibility
of trading impropriety. In addition, passive management reduces
the overall expense ratios, which gives the underlying securities
in the index fund a better chance to provide a good return.
The enemy is us. Unfortunately, the biggest threat by far
to most investors' overall rate-of-return is bad investing
habits (mostly linked to fear or greed). "Market timing" in
its traditionally-used sense (see my commentary above) is
almost always linked to emotionally-based investing. Rationally-based
investing that follows a thoughtful investment policy is
always the best course. Asset allocation and "dollar
cost averaging" are long-term investing strategies
that have stood the test of time.
As mentioned above, even if you are invested in one of the
implicated mutual funds, the impact on you is likely very
minimal. On the other hand, studies constantly show that
investors' own trading practices typically drive their
returns far below those of the funds in which they invest,
let alone reasonable market benchmarks. For example, a recent
study by the financial research firm, Dalbar, showed that
from 1984 - 2002 the average stock fund delivered an
average annual return of 10.2% while the average stock fund
investor earned only 2.6% annually per year:
Average Annual Returns, 1984-2002
This equates to
a cumulative return of 536% for the average stock fund versus a cumulative
return of only 63% for the average stock fund investor. Why the big difference?
In a nutshell, fund investors exhibited signs of emotionally-driven investment,
with fear and/or greed the primary motivations.
So, while we are right to be indignant about the (at least) immoral and (at
worst) illegal activities among some in the mutual fund industry, I believe
investors should focus on fundamental investing principles. In other words:
we should refrain from shooting ourselves in our respective feet!
The Bottom Line on Mutual Funds
Now is not the time to lose confidence or bail out of mutual funds altogether.
Mutual funds remain, in our opinion, the investing vehicle of choice for most
investors. The good ones offer professional management of a basket of individual
securities at a reasonable cost. We continue to champion broad diversification,
primarily through index funds such as those from Vanguard, and disciplined
investing practices such as “dollar cost averaging” (regular and
systematic contributions into an investment account) and annual rebalancing
among asset classes.
Things to Do Now
» Year-end is an especially good time to examine how your mutual funds
have performed for you (don't just look at the published return). You
should do your best to determine how much you are paying for the funds and
contact the company directly (or your financial advisor) if you are unable
to figure out your costs.
» Make sure that the funds you hold are part of a long-term investment
policy that includes your personal preferences on risk and long-term goals.
Consider your rate of return after taxes, transaction costs and inflation.
» Consider the mutual fund company's user-friendliness. Are the
materials clear and easy to understand? Are the company representatives helpful?
Does the company put investors first? Look for reputable firms with transparent
costs (low-cost index funds as well as managed funds). There are companies
that operate ethically, put the investor first, and charge fair and transparent
fees. If you are in your accumulation phase of life, you have the responsibility
of preparing for your own retirement; no generation before has ever had to
do as much to get ready for retirement. Not only will you need to accumulate
a sizeable amount of money in accounts earmarked for your retirement, but you
will need a strategy to make that money grow (you will probably need to outpace
taxes and inflation at the bare minimum).
» If you are in your distribution phase (retired and taking withdrawals
from your life-long savings), you will want to include mutual funds on some
level throughout retirement (assuming you need some continuing growth).
» All investors need take a more active role in understanding what they
are purchasing. Fraud is not something the mutual fund investor can control.
You can, however, do more to demand accountability from the funds themselves
and the employers who position these funds as the retirement vehicle for accumulating
» Be aware that unscrupulous brokers (sometimes cloaked as "financial
advisors" or "investment advisors" who are actually sales
representatives for an investment or insurance company) may try to take advantage
of the current Mutual Fund Scandal situation. While there are many ethical
and competent advisors who work on a commission basis, the surest way to secure
independent, objective advice is to work with "a fee-only advisor." Fee-only
advisors do not receive third-party compensation in any form, thus there are
no sales-driven incentives tied to their recommendations.
The Good News Going Forward
The turbulence going on in the Mutual Fund Industry right now should produce
some positive outcomes. Poor fund governance, which many industry experts say
is at the root of the allegations of market timing and late trading, was previously
hidden to investors. Watch for new regulations from the governing bodies. These
new checks and balances will help to better protect investors against unethical
practices. Also look for additional policing within the financial services
industry. Despite the uncovered abuses, and the ones that are sure to surface,
the fact is that mutual funds are an important part of the financial structure
of the country. Americans need and want mutual funds to work for them. Industry
leaders, and state and federal regulators, will be working hard to bolster
investor's confidence and put the additional safeguards in place.
Thanks for reading. As always, we welcome your comments or questions.