Bad news always seems to come in waves and the mutual fund industry is certainly no exception.  For years mutual funds were seen as a safe, dependable and easy way to build a retirement portfolio.  Today that is largely true, but investors are learning that they still need to pay attention to the investment products they are buying and whom they are buying from.  Recent events have shown that many mutual fund companies have certainly done their share of bilking unsuspecting investors through shady trading practices and shifting fee structures.

Starting last summer the industry was rocked with three separate scandals
that have caused most investors to wonder if their money is safe with
anyone.  Currently five of the 10 largest mutual-fund companies have been
implicated to some degree in one or all of these recent abuses.

Hedging their bets

The first scandal was the disclosure by the New York Attorney General’s
office that many firms were providing special deals to hedge fund companies that were detrimental to the individual fund investors.  Simply put, fund companies were allowing hedge funds to buy at yesterday’s prices after today ’s market had closed.  In other words, a hedge fund manager could bet on a horse after the race was over and before anybody else had collected on their bets.  If the price was up from the previous day they could profit by buying, if the price was down they could profit by selling.  The fund companies were very accommodating to the hedge companies because of the large dollar amounts they routinely traded.  Once again the small investor lost out to the big investor.

A matter of timing

On the heels of this event, which caused many of the big fund names in the
mutual fund industry to re-evaluate their policies, there was the issue
related to the timing of international fund purchases.  In this case, large
investors were making use of the different closing times of international
markets to exploit mutual fund prices that would lag behind the value of a
fund's underlying securities. Though not necessarily illegal, it ran contrary to their stated policies and became more damaging when brokers or funds allowed some investors, but not others, to engage in this practice.

Breaking points

The third and most recent event dealt with break points.  Most funds that
charge up front sales fees levy a charge between 4.75-5.75%.  If an investor buys large amounts of funds from the same family, they are entitled to a “break point”, or reduction in the front end or sales charge that they paid. Investors also have the option of accumulating their purchases over a 12 month period and still be entitled to the discount.  By hitting the break
point an investor can reduce the charge by a half to full percentage point
With large purchase volumes and a long term investment horizon, this savings can be significant.

When this problem first surfaced the mutual fund companies were quick to
take action.  Recently investors have been receiving questionnaires from
mutual fund companies that they had purchased shares in.  The questionnaires are asking them for information related to the number and dollar amounts of shares they had purchased in the last 12 months.  Companies are checking to make sure breakpoints were received by those entitled to them.

The problem was that many brokerage firms chose to keep the savings from the breakpoints for themselves and not pass it all to the customer.  In some cases the mutual fund families looked the other way because of the large volume that  a particular broker was doing.  Once again the fat cats came out fine, while the little guy suffered.

Looming ahead: the cost of doing business

The next area that I think we will see more problems with is the area of
fund expenses.  There are many different types of expenses that mutual fund companies charge fund holders and they are all regulated by the securities industry.  However, just as we saw with trading practices, which are also regulated by the securities industry, much of the information with fund expenses is often overlooked.  

In looking for potential sources of abuse a good place to start is with the 
12b-1 fee.  This fee came to life in 1980 after authorization by the 
Securities Exchange Commission. Its name came from the section of the 
Investment Company Act of 1940 that allows a mutual fund to pay 
distribution and marketing expenses out of the fund's assets.  The 12b-1 fee’s original purpose was to help the investor by splitting out the various fees that a mutual fund could charge.  Originally this fee was only to be used for marketing and distribution expenses and could not exceed 1%, and no more than 0.25% could go to the brokers selling the fund.

However in a survey conducted in 1999 by the Investment Company 
Institute (ICI), 63% of this expense went to brokers for distribution 
expenses, 32% went to administrative expenses related to share holder 
service and only 5% was used for marketing and promotional activities.

In practice this fee is often used as a hidden sales load to compensate brokers for selling the fund.  Most mutual fund companies offer multiple classes of the same fund.  Class A shares typically involve a front end sales charge and low 12b-1 fees, while Class B shares have a sales charge that is levied only if you sell the fund in the first few years.  Often overlooked is that the Class B shares typically carry a higher 12b-1 fee that can seriously erode your returns over the long run.

As you can see, whether you are a do-it-yourselfer investor or work with
an investment advisor, you should be aware of what is going on with your 
money. Mutual fund companies routinely fill your mailbox with all kinds of information.  Some of it is useful and quite frankly most of it is pretty boring, but you should take the time to go over it or discuss it with your advisor.

An important rule of investing is to keep a close eye on your expenses. Fund expenses represent lost dollars and should be managed carefully. Whenever you are evaluating your expenses of investing, ask yourself if you are getting a fair value in exchange for the expenses you are paying.   If you are getting a good deal, stay the course.  If you think someone is trying to pull a fast one, you better start looking around for a better deal.

Contact Mark Neil at:
Northwest Wealth Advisors, Inc 
0605 SW Taylors Ferry Road
Portland, OR 97219
Office: (503) 478-6632 
Fax: (503) 595-1863 
Email: mneil@nwwealtadvisors.com 
Website: http://www.nwwealthadvisors.com/

© 2004 Mark Neil