THE SAVINGS GAME

Weed out funds that fail high standards

By HUMBERTO CRUZ Tribune Media Services

Saturday, November 22, 2003

As helpless and confused as we may feel about the ever-growing mutual fund scandal, we the individual investors have the ultimate weapon to fight back.

That weapon is our money, which we should entrust only to those funds that show, by their actions, that they actually care about us.

But first, we need to understand what’s going on.

The main allegations against fund companies and now also brokerage firms involved in the scandal are that they allowed a few favored big-money shareholders, such as hedge funds, to engage in late trading and market timing of mutual funds.

Late trading, which is illegal, involves the placing of buy or sell orders for mutual fund shares after the stock market has closed for the day at 4 p.m. Eastern time, but using that day’s closing price. By law, those orders should receive the next day’s price.

Shareholders allowed to engage in late trading profit illegally from the knowledge of events that occur after the market has closed when those events can be expected to affect the next day’s share price a certain way. These illegal profits in turn dilute the returns that other shareholders like you and I would get.

Market timing, which is the rapid-fire trading of fund shares to profit from short-term market swings, is not in itself illegal. But most funds have policies against it because market timing drives up fund transaction costs and can disrupt management of the portfolio.

Trust broken

Despite these policies, which are typically spelled out in the fund’s prospectus, several fund firms allowed big-money investors to market-time, sometimes with the knowledge and consent of the fund managers — and, in some cases, their active participation.

In perhaps the most egregious case, Richard S. Strong, who has since resigned as chairman of the Strong mutual funds but still heads the management company, admitted he market-timed shares of his company’s funds for his personal gain and that of family and friends for years, allegedly netting profits of at least $600,000.

The impact of all these actions on individual investors’ bottom lines is hard to quantify, and for most of us may in fact be minimal. But the psychological impact is severe and will likely be long-lasting.

Simply put, our trust has been broken, our confidence betrayed. The once-pristine mutual fund industry has shown it often operates by two sets of rules — one for the small investor, another for the big-money players.

But even before the latest revelations, the interests of the small investor often got shoved aside in the name of “asset gathering,” or getting as much money into a fund as possible so the fund companies could collect more management fees. “Asset gathering” was the reason behind the performance-touting ads many fund firms ran at the height of the technology bubble in 2000, enticing naive investors to jump into their super-risky funds.

Asset gathering was the reason the number of technology mutual funds ballooned from 28 in 1995 to 328 by the end of 2001, by which time the tech bubble had already burst.

Set your own standards So what to do now? If you are invested in a fund involved in the scandal, the damage has already been done (and in most cases, the fund firms have promised to make restitution to investors for any losses or lost profits). There is no guarantee that if you invest in a new fund, that fund too won’t be caught in a scandal. And for diversification and professional management, mutual funds still make eminent sense for small investors.

The danger of staying put in a scandal-tinged fund, on the other hand, is that with many other investors selling, managers in some of the affected funds are being forced to sell securities in the portfolio to meet redemption requests, driving down share prices.

So here is what I suggest: Take this opportunity to review your portfolio and weed out funds that do not meet what I call “shareholder-first” standards. Here are some of the things I would look for:

Low annual expenses. While there has been no “scandal” associated with it, I find it outrageous that the average annual expense ratio for stock mutual funds, despite economies of scale as assets grow, continues to creep upward and now stands at 1.51% a year. (That means on a $10,000 investment, $151 a year is taken out by the people who run the fund.)

I see no reason to pay more than 1% in annual expenses for an actively managed domestic stock fund that invests in large-cap and midsize stocks. Fund companies with below-average expenses and excellent long-term returns include Vanguard, TIAA-CREF, Dodge & Cox, T. Rowe Price and Fidelity. American Funds, sold by brokers, impose a sales charge, but after that annual expenses are below average.

No “performance” advertising and no hype. You can’t use past performance to predict future returns anyway. Among the big no-load funds, Vanguard as a matter of policy does not run performance numbers in ads. The American Funds, sold by brokers and financial advisers, do not advertise, period, preferring to spend the money on stock research.

Candid and clear communications. Rather than come up with excuses, or blame “the market” when things go bad, fund managers should own up when they make investment mistakes. It is a mark of honesty. Fund managers who do so and inspire my confidence include those from Ariel, Bridgeway and Royce funds.

A clearly stated and followed investment discipline. You know from reading the prospectus and the fund reports how the manager picks investments and why. And the fund company should not be constantly launching new funds to gather assets from investors chasing after the latest “hot” market sector.

Funds with a long-term discipline and highly successful long- term results — and no new “fund of the month” each month — include Longleaf Partners and Dodge & Cox, arguably among the best two fund families most people never heard of.

A manager who manages rather than does PR. I prefer never to see a fund manager on CNBC or CNNfn because that’s time spent on asset gathering rather than on managing the fund. A fund manager who rarely grants interviews and whose name you probably won’t recognize is Ed Owens, who has guided the Vanguard Health Care Fund to an average compounded return of 20% a year since the fund began in 1984.

This is not an exhaustive list of criteria or of funds by any means, and you would do well conducting your own research of funds at Web sites such as www.morningstar.com, which is run by the Chicago fund analysis firm Morningstar Inc.

Also, my naming a fund does not mean I am recommending that you buy it. You need to research the fund first and make sure it fits within your goals and risk tolerance. But following these guidelines should improve the odds of choosing a scandal-free fund, and one that will perform well over the long haul.

Humberto Cruz can be reached at AskHumberto@aol.com or c/o Tribune Media Services, 435 N. Michigan Ave., Suite 1500, Chicago, IL 60611. Questions will be addressed through his columns, but personal replies are not possible.