NEW YORK (CNN/Money) - The emerging scandal in the mutual fund industry already has some financial planners pondering the impact of the scam on their clients' assets, and asking whether those clients would be better off investing in other instruments.
The case involved Canary Partners, a hedge fund run by Edward Stern (son of Leonard Stern, the chairman of Hartz Mountain, the pet products company) and several mutual fund companies: Janus, Strong Capital Management, Bank One, and Bank of America.
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In announcing a settlement that resulted in a $40 million fine and reimbursement package, New York State Attorney General Eliot Spitzer alleged that the mutual funds had allowed Canary to both trade fund shares after the market closed and engage in illegitimate market-timing maneuvers.
All of the funds involved are "big, mainstream funds," notes financial planner Mark Balasa. "It makes you wonder what else is going on out there."
For the moment it won't make him stop recommending mutual funds to his clients, although, he says, it does give you an additional pause.
A black eye for the industry
The emerging scandal could become one of the worst in Wall Street history, charges Mercer Bullard, a former SEC lawyer and founder of Fund Democracy, an advocacy group. "It goes beyond anything that's happened before."
The news hasn't yet sunk in for most mutual fund investors but one posting on Morningstar's Web site wrote: "I can't believe a mutual fund family, knowing late trading is illegal, would go ahead and do it anyway."
Rick Applegate, president of financial advisor Strategic Capital Concepts, says that he has not had to field any calls from outraged clients, but he himself expressed great concern.
After two years of getting buffeted by scandals involving Enron, Worldcom, Imclone and other individual stocks, Applegate finds himself "disheartened" to learn of the mutual fund scandal.
Since mutual fund investment -- in the form of retirement and other accounts -- is so widespread, it has the potential to harm many more investors than any of the stock scandals did.
Even so, Applegate says he won't alter his advice to clients, at least not until "much more comes out on how common the practice was."
Certified financial planner and author of Let's Talk Money and Decoding Wall Street, David Caruso says if he finds that this turns into a major scandal and it's costing his clients substantial money he'll look carefully at changing those investments.
"I don't want to overreact," he says. "But if it turns out this scandal is of biblical proportions, a lot of money will leave the mutual funds."
Some alternatives to mutual funds
Caruso won't pull money out of mutual funds immediately. "That doesn't make sense tax-wise," he says. The capital gains tax could wipe out any gains from taking that step.
There are, however, a few alternative investments he would consider for his clients who decide to shift out of funds. These are:
- Exchange-traded funds take the stocks within an index, bundle them up and let you buy and sell them as one, just like an individual stock. They trade heavily, openly, and their prices change constantly, leaving no room for head funds to arbitrage "stale" prices. ETFs are more diverse than an individual stock and more flexible than a traditional index mutual fund.
- Index funds are portfolios of stocks that are designed to track as closely as possible the returns of a stock-market index or benchmark (such as the S&P 500). Best suited for long-term investors, index funds are passively managed and carry low costs. Since they basically track the whole market, they're not subject to the same kind of manipulation that funds with more specialized holdings are.
- Privately managed accounts. Both Applegate and Balasa said they might encourage some of their higher asset clients to switch to an account in which their private money manager would buy stocks for their individual accounts.
The real worry is that the scandal could balloon. Already, it is rumored, mutual fund managers are contacting attorneys to find out what their legal liability might be.
Bullard says that from what he hears, Canary was not alone in its practices. "There are lots of hedge funds making a living doing these kinds of trades," he says.