What You Should Know About The Mutual Fund Scandal

In the past, most of the problems within the mutual industry have been associated with greedy brokerage firms or brokers rather than the mutual fund managers themselves. We have warned about the disadvantages to the investor of Class B shares by commenting that the only one that benefits from Class B shares is the seller or broker. Regulators are now probing brokers that pushed Class B funds when other classes of funds would have cost the investor much less. Over the past year news has come out that several brokerage firms failed to credit the appropriate sales commission discount on larger purchases of Class A shares. Currently, Morgan Stanley is being investigated by Massachusetts, and was fined $2M by the National Association of Securities Dealers, for encouraging its sales force to sell more in-house funds with cash prizes. Morgan Stanley’s clients were never informed of those cash incentives. All of these separate scandals have been generated by brokers putting themselves first rather than their client. That was until last quarter when New York Attorney General Eliot Spitzer, made public serious allegations regarding many of the largest mutual fund companies. The source of many of these violations was the actual money manager or mutual fund companies themselves and not simply the greedy brokerage industry as it has been in the past. Serious breeches of fiduciary responsibility are allegedly involved within an industry in which trust is everything. It is hard to believe that those mutual fund families would risk their reputation for the sake of more fees but that is exactly what transpired. So what should investors do if they own one of the fund families guilty of wrong doing? At soundinvesting.org we have always stressed finding the best investment for a one’s specific investment objectives and risk tolerance and with so many mutual fund choices it does not make sense to stay with a fund company that you cannot trust. There are certainly other considerations like tax implications when getting out of such funds. In general, you would be better off with management that shares your interest rather than ones that could be actually working against you in favor of large investors and hedge funds. This same principal of looking for the best funds, with the most favorable risk parameters, leads us to funds with the following attributes that may also limit scandals:

• Majority of money managers net worth is in his/her funds
• Managers that close their funds when assets grow to meaningful levels
• Managers that do not establish new hot (i.e. internet) fund of the period or advertise short periods of dramatic outperformance
• Managers that avoid the conflicts of interest with managing a hedge fund concurrently with a mutual fund
• Managers that put limits on trades and even establish redemption fees for shorter term trades
• Managers that have independent client compliance officers that report to independent board of directors

FORTUNATE TIMING

We like the way stocks have taken one step back to spring two steps forward since hitting its low in October 2002 and testing those lows in March 2003. After such huge gains it is wise to buy on weakness (one step back periods) and not chase those speculative stocks and funds that have done so well. The scandals summarized below, within the mutual fund industry came out after the latest rally that left most investors much more sanguine about stocks in general and mutual funds in particular. The timing was very fortunate because if these scandals would have been made public last year, when many investors were suffering from their third consecutive year of losses, there would have been a more meaningful impact on mutual fund out-flows. Investors should also realize that the current investigations will certainly dig up more but that the loss of your money due to fraud is remote. The allegations are more concerning the dilution of your gains by mutual funds favoring the large investor. To date the worst of the culprits seems to be the Strong Funds, PBHG Funds, Putnam Funds, and Alliance Capital. Highly placed executives in these fund families were aware of the wrongdoing and maybe even played a part in it. Most of these funds have loads (sales commissions) and/or charge above average operating expenses. In addition, many of these funds had below average performance. Here are the dozen with the most serious allegations in the investigations so far:

OneGroup – BankOne’s mutual fund division

Federated Investors – select investors were granted preferential status said it will reimburse other investors

Fred Alger Management –high expenses & loaded

Janus Funds – soundinvesting.org warned about this group during internet craze over three years ago

Nations Funds –Bank of America’s main fund group

AllianceBernstein – another with high expenses & loaded

Putnam Funds – lost largest amount of assets due to investor departures to date

Scudder Funds – owned by Deutsche Bank

Invesco Funds – problematic alliances with Deutsche Bank

Strong Funds – founder Richard Strong departed after directly participating in market timing for his own account.

PBHG Funds — Pilgram Baxter & Associates alleged illegal and improper trading in funds

Charles Schwab Corp. — investigating illegal mutual fund trading including possible cover-up (deleted emails)

It should also be noted that several Merrill Lynch and Prudential Securities brokers have already been implicated in facilitating illegal late trading in several various mutual funds.

Hiding The Load In Mutual Funds

A load’ is simply the mutual fund industry’s term for sales charge, which is a fee investors pay directly out of their investment. In recent years, as investors have become more sophisticated, there has been a trend toward devising various alternatives (methods for investors to pay the sales charge). These payment methods are referred to as multiple classes of shares, and have greatly added to the confusion of purchasing mutual funds. Multiple classes of shares are shares sold from the same fund with a different sales load charged for each share class. Here are the most common share classes currently sold with their pricing or cost structure:

• Class A Shares are sold with a front-end load. The sales charge is deducted directly off the top of your investment and paid to your broker with the remainder invested in the fund. This sales charge can be as high as 8 1/2%, but due to the market enviroment it has been averaging 4 — 4 1/2%.
• Class B Shares generally charge a back-end load for exiting a fund within 5-7 years of purchase. This fee is sometimes called a Contingent Deferred Sales Charge (CDSC) or a surrender charge. A back-end charge typically starts at 5-6% of the redeemed assets during the first year of purchase and declines by one percentage point each year until it reaches zero. However, since the broker must be compensated for selling the fund whether or not you redeem in the first several years, B shares often have higher annual expenses paid out in the form of a 12b-1 fee. After the back-end load expires (5-7 years), the 12b-1 fee is no longer deducted from the funds assets and the B shares convert to A shares.
• Class C Shares are often referred to as level load shares. While they do not charge either a front or back-end load, C shares deduct a 12b-1 expense each year for the life of the investment.
• Institutional Class Shares are available for the larger investments or through an advisor that has already established minimum criteria. The total expense ratio on these funds is usually significantly less than the same fund via other class shares. For example, the American Century Income and Growth Fund Advisor Class Shares have a competitive 0.94% total expense ratio, while the Institutional Class shares of the same fund total expense ratio is only 0.49%. It pays to check out all your options before you invest — as the above example illustrates a nearly 50% cost savings each year by purchasing the appropriate class shares of the same fund.

Most A shares offer reduced sales charges for large purchases at various breakpoints. An investor that purchases less than $10,000 in a typical Class A fund will pay a 5% sales commission. A purchase worth $50,000 may result in a 3.5% commission. Usually, the sales commission is waived at $1 M, but you still may pay a 12b-1 charge that is taken out internally each and every year.

It should be noted that B and C shares do not reduce commissions on large orders. The broker typically receives a flat commission of 4% for these orders. Similar to the 12b-1 extra fees, the client does not notice the commission because it is taken out internally from the annual expenses. Thus, class B and C shares are very expensive over time and should always be avoided for large sums. In fact, mutual fund companies are suppose to discourage large sales of B shares. Many have set limits of $200,000 for such shares, but brokers may still find funds that don’t adhere to the rules or find ways around the limits. There are also virtually limitless combinations of the above charges, such as Class M shares having a smaller front-end charge than the Class A combined with a more modest 12b-1 charge than Class B or C.

There are two significant points investors should keep in mind when looking at different share classes of mutual funds. First and foremost, none of the above mentioned fees will add to your investment performance as the fees are deducted from the amount you invest simply to pay a broker. Secondly, it is the investor’s responsibility to determine the fees (and hidden sales charges) on all mutual funds before they invest. While cost should not constitute your sole reason for purchasing a fund, it should play a critical role in your investment decision.

A Look into No-Load Mutual Funds

First of all, lets discuss the cost equation of mutual fund investing. Total costs are often overlooked by investors many times due to confusing sales practices and overly creative marketing techniques. A variety of different sales charges and fees have been introduced over recent years that make cost analysis even more confusing to investors. In fact the term no-load can no longer be construed as meaning no sales charges or added fees as it has in the past. Currently, investors must look for true or pure no-load to assure themselves of not paying any of the following various charges:

• Front-end sales charge — an initial one time deduction from your investment made into the fund, usually ranging from 3.0-5.5% on each and every purchase.
• Back-end sales charge — a deferred charge imposed when you redeem shares of the fund. Typically this charge declines over time but an additional 12b-1 charge is also usually imposed every year.
• 12b-1 charge — an additional charge deducted from the fund each year to pay for distribution and marketing costs.
• Redemption fee — is the amount charged when money is withdrawn from the fund typically only applicable for short period of time, often 30, 60 or 90 days.

Investing in funds with any of the above charges only reduces the amount of your investment dollars at work for you. In addition, studies have shown that funds with 12b-1 charges have, on average, taken more risk in attempts to compensate for their added charges. It should also be noted that all mutual funds will have ongoing administrative fees (the cost of running the fund) and management fees (the cost for managing the fund’s assets) in addition to the varied transaction expenses in managing the assets. We use over 20 investment criteria over and above, our low expense and no-load parameters in selecting the most appropriate fund for each investor’s specific situation. Some of the most important aspects in the selection process will be the defensive measures that fund managers incorporate to preserve capital and reduce volatility. This analysis will be particularly important during more turbulent market environments as opposed to what we experienced in 1995. In other words, they are much more relevant now than they were last year. Other important variables to analyze in addition to the fund’s investment and risk parameters, include turnover ratio and capital gains exposure. This will not only give you a good idea on the style of the fund manager, but also can limit the tax liability to the individual investor.

The Real Cost of Mutual Fund Wrap Accounts, and Fund of Funds

The positive aspect in purchasing true no-load mutual funds can be totally negated if such purchases are made through wrap accounts or fund of funds. Wrap accounts are brokerage accounts that purchase a variety of mutual funds under one (wrapped) account in your name. Fund of funds are mutual funds that pool investor’s monies together to purchase a portfolio of various mutual funds. Both charge an annual fee of usually between 1-2%, on top of your ongoing cost of each and every mutual fund held. Instead of purchasing a low cost competitive group of mutual funds, investors typically get what turns out to be a high cost investment vehicle (similar to Class C mutual funds), with annual expenses as high as 4% or more.

Example: Investor #1 and #2 invest $10,000 over a 25 year period. Both investors receive a return of 12% annually over this period, but investor #2 has a wrap account that charges an additional 2% each year. After the 25 year period, investor #1 has $61,654 more from his/her original $10,000 investment than investor #2.

$10,000 Grew To:

Investor #1: $170,001 @ 12% Annually