By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

With regulators and many board members asleep at the switch, the $7 trillion invested in mutual funds was bound to tempt some unsavory activity. And it did.

Not withstanding the general level of disgust we all feel, investors shouldnt rush to abandon mutual funds. Mutual funds provide the best method of achieving investor objectives of low cost diversification across the worlds markets. Properly run, funds can level the playing field for the retail investor.

Only Exchange Traded Funds (ETFs) might be an appropriate alternative to the traditional open ended mutual fund. In markets and market segments where they are available, they are great, but at present many desirable asset classes can not be purchased through ETFs. Investors that wish to diversify beyond the vanilla large company US and foreign developed markets will find scant pickings.

Its patently absurd to believe that a separate account would provide greater protection against mischief than a traditional mutual fund. There is no possible way that regulators or compliance officers can keep track of millions of different separate accounts. What you will get with a separate account is higher cost, higher risk, lower diversification and a certain amount of ego satisfaction. While ego satisfaction is certainly an effective marketing technique for separate account sponsors, in every other respect investors would be better off in funds. That hasnt kept the separate account folks from shamelessly promoting themselves anyway.

Hedge funds and most other alternative investments are even worse. These investments lack the basics of regulation, disclosure, transparency, or accountability. In most cases you would be better off at the dog track.

None of this is to suggest that investors should put up with a dishonest fund. They should pull their accounts from funds or companies that cheat. There is nothing to be gained by supporting proven criminals and liars. The argument that now that we have been caught we are going to reform just doesnt get it. But, even here, investors will have to use a little judgment. Its one thing for a fund company chairman to trade his own account after hours, and another to find that a rogue employee has crossed that same line.

In the end, there is no substitute for integrity re-enforced by good corporate governance. A few fund families stand out as examples of both. Based on long personal experience, I will be greatly surprised if Vanguard, USAA, TIAA-CREF, American Funds, or DFA are dragged into the scandal. Im sure that there are many others that operate in the shareholders interest as well.

Rather than abandon funds as the investment medium of choice, investors should become more discriminating by seeking out fund firms that deserve their trust. Meanwhile, keep up the pressure for meaningful reform and vigorous enforcement. And lets all toast Elliott Spitzer, who gets my vote for Man of the Year.