Are Mutual Funds a Sham?

October 15, 2003

As the Powerfund Portfolios are primarily mutual fund focused, some of you are probably wondering what our take is on the burgeoning mutual fund scandal. Are mutual funds bad news, MAX, and what can an investor do to avoid being ripped off?

While there are hundreds of articles about the specifics of the shady dealings at Janus, Strong and others, little has been written about the actions investors in these funds should take.

First of all, don’t give up on funds entirely. Besides the fact that most funds are on the level, there is frankly no place else to go. If you read about the financial scandals from the last few years, you’ll find the brokerage industry is far more weasely than the relatively clean fund industry.

Second, you may want to bail out on funds that are in trouble. While we are fairly certain the funds under investigation have stopped doing what they are accused of doing, the fallout from their actions will probably be bad for investors. Specifically, funds with major outflows of cash from disgruntled investors can under-perform indexes and other similar funds because the manager has to sell stocks. All other things being equal, this will send stock prices, and therefore the fund’s NAV, down. Call it the mutual fund death spiral.

Besides, do you want to reward a fund company with management fees drawn from your investment after they worked with others to systematically loot you? If for no other reason, you should sell your shares out of principle.

For the record, broadly speaking fund companies are being accused of allowing and profiting from certain large investors trading in and out of their mutual funds at opportune times and/or in apparent violation of the rules you have to follow. Worse, their profits from such activities can sometimes come exclusively from your returns, or at least cost you money as you subsidize the behavior.

But what can a fund investor do to avoid being the pasty in this great mutual fund swindle? We’ve made a list. While any one of these warnings signs taken alone may not be reason to head for the hills, several of them together at least set the stage for trouble.

Call it mutual fund profiling. While in a court of law you need to prove beyond a reasonable doubt that a crime was committed, as an investor you may simply want to avoid a fund that smells fishy. You are allowed to discriminate when investing. Be unfair and unjust. Don’t give funds the benefit of the doubt. Why should you? There are thousands of funds to choose from?

Rule 1: Avoid load funds

The motive for all fund companies is simple: make more money. However, for most no-load fund families, making more money is best achieved by having the best performing funds. Past performance (often unfortunately) sell itself, and a fund that beats competitors brings in far more money than any short con will generate.

Because of this fact it is very unlikely that a typical no-load fund family would do anything that would significantly compromise fund returns.

Load fund families can’t say the same thing. Load funds are not just sold by past performance, they are sold by brokers to often less-than-knowledgeable clients. As we wrote in a recent article about Morgan Stanley, load funds may be sold by a broker because the broker is competing in some Glengarry Glen Ross type commission competition, not because it’s the best fund for the client.

Rule 2: Avoid fund families with major business interests besides the funds themselves

This one is tough to watch out for because almost every fund company has some sort of business going on besides the mutual funds they manage, be it separately managed accounts, hedge funds, or brokerage services. The basic concept here is if mutual funds is a company’s main source of revenue, they are less likely to do anything to compromise their core business.

If the fund company is really a large bank (say Bank of America who is in hot water for their fund dirty dealings) they have other interests besides mutual funds. They may have rich ultra-high-net worth clients, or hedge funds that pay higher fees than mutual funds.

How do you know if your fund is facing a possible conflict of interest? Call the fund advisor and ask them how much money they have under management, and how much of that is in funds versus other products. Find out if they do brokerage or investment banking operations, or manage hedge funds. Again, most funds with side businesses are legit, but why be in their non-priority product when there are plenty of great investment companies out there to whom their fund business is their only business?

Rule 3: Consider index funds

While MAXadvisor primarily uses actively managed funds because we feel we are expert enough to chose above average funds, index funds offer an unusual benefit in the war against fund crimes and misdemeanors. Fund companies can’t let index funds get ripped off because it would be painfully obvious if a fund missed its benchmark index by 1 or 2% a year.

Rule 4: Avoid large funds

No self-respecting greedy Wall Street operator is going to break the rules for an investor with $100K or even $1M dollars, but some will look the other way for somebody with $50 or $100 million. But there’s a hitch. Funds can’t let an investor with $100 million go in and out of a fund every few days if that fund only has only $150 million in total assets. Transactions of that size would wreak havoc in a small fund.

Recent scandals have been giant funds allowing big fish investor to steal a little from a mammoth fund. High turnover can be a clue there is hot money in a fund because the fund manger has to trade frantically to meet the subscription and redemption demands of criminal timers.

Rule 5: Avoid hot money

A fund with a stable asset base has many benefits, and none more relevant than this: a stable asset base usually means there is no massive in and outflows of investor capital. Avoid funds that swing from $500 million, to $1.2 billion, and back to $700 million, all in one year. It means the fund has been taken over by timers and short-term players – to the detriment of a longer-term investor.

Hot money can be kept at bay by avoiding funds that have no short-term trading restrictions, avoiding funds that are very common on fund brokerage supermarkets, avoiding funds with recent hot track records, and funds that allow easy transferring in and out of their funds. Sadly, redemption fees, which are a good thing, are not an end all be all stop to hot money because fund companies often waived the redemption fees for “preferred” clients.

Rule 6: Consider closed end funds

Closed end funds have quite a few downsides, the main one being the market price can have little to do with the actual fund’s investments. However, these fund’s fixed portfolios are by definition free of timing and late trading scams. Closed end funds can be particularly useful for foreign and fund categories that tend to invest in less liquid securities, which can be more easily mis-priced in an open end fund.

Rule 7: Avoid management and control changes

We’re not just talking about fund manager changes here. Sometimes, key executives leave fund companies they founded. Or they sell their fund company to some giant bank. Or there is infighting. Either way, changes in management can lead to lack of authority or worse, lack of care. Some large bank doesn’t think of a fund family they bought as anything but a way to make money. If they can dream up synergies that can make them more money, so be it. To them, a fund is not a place shareholders put their trust, but a simple formula of assets times management fees.

When considering a new funds investment, keep this list in mind. The increased regulatory scrutiny will surely cool down they types of activity , however, most of these rules outlined above are good ones to follow, and rules we have recommended from time to time for years at MAXfunds.