Mutual Funds not so "mutual"

Editor's note: Marc Leavy,CFP? is a regular financial columnist for Business Reform Magazine, the leading Christian business magazine with over 100,000 readers. Each issue features practical advice on operating successfully in business while glorifying God.

Mutual funds have been heralded as the investment for the "little guy". However, some of the nation's most well known mutual fund companies got into trouble with NY Attorney General Elliot Spitzer.

Catching many in the fund industry by surprise is Spitzer's claim that four fund families?Bank of America Corp.'s Nations Funds, Bank One Corp., Janus Capital Group Inc. and Strong Funds?permitted favored companies and individuals to engage in illicit trading while stating in their fund prospectuses that they discourage or prohibit such practices.

To appreciate the scandal, let's clarify some terms. An open-end mutual fund is a basket of stocks and/or bonds managed by a professional money management company. The price of the mutual fund is calculated at the close of the trading day. At the close, the price is set for the open tomorrow. This is the "Net Asset Value" or NAV. The NAV does not vary during the day, as does the price of a stock. The investment objective of the mutual fund is clarified (hopefully) in the prospectus.

A hedge fund is an investment for accredited investors (rich people). The hedge fund has a much broader discretion as to what it may buy, sell or even short. (Shorting is selling first and then buying the stock back when the price drops. It is not as easy as it sounds.)

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Many publicly traded stocks announce their earnings after the close of business day. This is done for a variety of reasons, as not to disrupt normal trading, If good news comes out in the evening, investors react and get into the market the next trading day. What appears to have happened is that mutual fund companies allowed hedge fund managers (Canary Capital in particular.) to wait for the good news, buy the mutual fund the same day?allowing the hedge funds to get in ahead of everyone else. Wouldn't we all like to be able to hear the good news first and then be able to go back in time and buy before everyone else does? It is also alleged that hedge funds were allowed to see current holdings of the funds. Something you and I are told is "not possible".

Why would a mutual fund allow a hedge fund to trade ahead of you? Money, of course. The hedge fund would in turn bring its stock trades to that investment company, thereby generating commissions for that mutual fund company.

Some traders say hedge funds have long participated in "timing" trades for fast profits, with mutual funds' approval. "Everyone has been doing this trade," says Stan Jonas, managing director of Fimat USA, a derivative-trading firm that is a subsidiary of Societe Generale. "It has been the biggest lay-up in the last five years." In other words, "Hey, everybody does it"?except for us schmucks on Main Street.

Other major financial players were subpoenaed to provide data about mutual fund trading. Millennium Management LLC, a hedge fund with some $4 billion in assets along with mutual fund giant, Vanguard Group, the nation's second-largest fund company measured by assets (behind Fidelity Investments), and Invesco Funds Group, a unit of Amvescap PLC, another large fund group have all been subpoenaed. More will follow. There is little doubt nearly every major fund family will be/has already been subpoenaed.

The Securities Exchange Commission (SEC) had indicated that it also would be launching a probe. The sense is there will be more subpoenas and accusations to come from the self-regulatory bodies.

In my last column for Business Reform, and here, I have discussed Exchange Traded Funds (ETF's), which are like an index fund that trades as a stock?e.g., the Dow Jones Industrials, 30 "industrial" stocks that comprise that average, trade under the symbol, DIA (Amex). ETF's are inexpensive to own, and as easy to buy and sell as a stock. Business Reform subscribers can refer to Innovative Investments in the last issue. Or subscribers can reference the article at www.businessreform.com under my name. You can also find information on ETF's at www.amex.com and www.ishares.com. Email me if you would like to discuss a managed account of ETF's for less than you would probably pay for a portfolio of mutual funds.
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Marc Leavy, CFP?,is a Certified Financial Planner who offers fee-for-service financial planning advice. Principled Investing teaches Solomon's principles of investing and offers wisdom regarding comprehensive financial planning without conflicts of interest from commissions. He may be reached at [email protected].