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'Mutual Fund Scandal' - A Commentary

By Lee Cullum, KERA 90.1 commentator

Dallas, TX – God help the small investor in mutual funds, because apparently no one else will. Certainly Bill Donaldson, chairman of the Securities and Exchange Commission, has been tepid in his response. According to one close observer, the situation is much worse than some in Washington would have us believe. The funds are praying, I was told; they can acknowledge their guilt with regard to market timing and bring to a close this whole messy business.

Market timing actually is not illegal. Hence the rush to mea culpas of convenience. Market timing means using the time differences around the world to get in and out of Japanese securities, for example, based on the assumption that a good day on the New York Stock Exchange will be reflected in the Nikkei that next morning. The problem is that the costs associated with the investor who buys one day and sells the next, regularly, are spread over the entire fund; so small investors get socked with them. More cash must be maintained by the fund to service the global high-rollers, so small investors don't have all their assets working productively either.

Late trading is an abuse that's definitely against the law and that has been embraced by some in the mutual fund industry. There are financial advisors that have allowed hedge funds to get their orders in after the closing time and pay that day's price if bad news about a company is set to be released the next day. This is information small investors don't have and even if they did, nobody would permit them to buy or sell after hours.

But these costs are negligible, said this observer, compared to the huge fees charged by advisors that look after several funds at once-the giants like Merrill Lynch or Fidelity. Over the past 30 years or so, the money invested in mutual funds has gone up 60 times, but management fees have soared 90 times. Nor have advisors hesitated to raise their fees during the recent bad economy. Moreover, they often give a much better deal to large pension funds, which pay about 3 percent than to mutual funds, whose tally can be close to 2 percent. The cost to small investors in extra fees paid over a decade can be as high as 10 percent.

The problem is that mutual funds have boards of trustees who can't be trusted with anything. They are controlled by the advisor earning the fees so they do nothing to negotiate with the advisor a better deal for their shareholders. Moreover, they permit the advisor to apply part of the commission to soft dollar accounts out of which operating office expenses including travel are covered. Why should mutual funds pay for that? If small investors wake up and realize they're getting bilked, it could be very bad for the stock market itself. In Japan, I was told, people lost confidence in the Nikkei and it suffered.

More is needed than independent directors, assuming a declaration of independence ever actually would occur. The House has passed a bill sponsored by Richard Baker, Republican of Louisiana, that also would require disclosure to investors of soft-dollar arrangements, compensation of fund managers, any holdings managers might have in the funds over which they preside, portfolio turnover rates, and the fact in brokerage account statements that fees have been deducted. The 4:00 closing time would be enforced for each trading day.

This is necessary legislation. The Senate should come up with something equally responsible, and the world of mutual funds should shape up before it destroys the faith of Americans in their financial system.

 

Lee Cullum is a regular contributor to KERA and to the Dallas Morning News.