NEW YORK (MONEY magazine) - At long last, the bull market is back. And not a moment too soon for long-term fund investors, who after three years of wrenching losses are finally being rewarded for their patience.
The average stock fund soared 31 percent in 2003 -- the first positive annual return since 1999.
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There's no getting around it, though: 2003 was a rotten year for fund ethics, as evidenced by the scandals rocking the $7 trillion industry. Since last September, when New York State attorney general Eliot Spitzer first charged the Canary Capital Partners hedge fund with improper trading of mutual funds, at least 17 investment companies have been roped into the scandal, including such well-known groups as Putnam, Strong, Janus and Alliance Capital.
The accusations have already led to the resignations of three top fund company executives: Putnam's Larry Lasser, PBHG's Gary Pilgrim and Dick Strong, founder of the Strong funds. And one executive implicated in the scandal, James Connelly Jr. of the Alger funds, received a jail sentence for evidence tampering.
The scandals, however, have not deterred investors from putting money into mutual funds. From the beginning of September to the end of November, stock funds took in nearly $64 billion, according to fund tracker AMG Data Services -- the highest three-month inflow since early 2000, when the market last peaked.
Still, fund investors, rightly, are proceeding cautiously. Some 55 percent of those dollars went to the nation's three largest fund groups: Fidelity, Vanguard and American Funds. That's up sharply from their average 36 percent share between 1998 and 2002.
Not so coincidentally, none of these companies have been implicated in the fund fiasco. "It's a flight to quality," says Burton Greenwald, a fund consultant in Philadelphia. "Investors as well as advisers are seeking out large, blue-chip fund companies that appear to have weathered the storm successfully."
Investors are also looking for regulatory action to clean up the mess. New rules may be on the way, but as always, it remains up to you to safeguard your portfolio. That means not only periodically reviewing your fund's returns but also giving consideration to the management's ethics. Says Russel Kinnel, director of fund analysis at Morningstar: "You have to ask yourself why you should trust the fund company."
It's important to point out that mutual funds remain one of the best ways to save and invest. For every questionable company, there are many more well-run, ethical fund groups.
For those of you who have not been obsessively following the fund investigations, here are four key questions and answers about the abuses.
How will the scandals affect my portfolio?
With more than a dozen fund firms accused of allowing inappropriate trading in their funds, the wrongdoing could touch investors in several ways. Most immediately, you might be a shareholder in one of the funds that was improperly traded, such as Janus Mercury or Putnam International Growth.
Or you might be affected because you own other funds managed by that company. Keep this one thing in mind: No one stole any money out of your account. Instead, a few investors benefited unfairly. Some of the impropriety involved late trading, or buying funds at outdated prices after the market closed, which is illegal.
The other, more common, problem was fast trading -- buying and selling a fund within a couple of days to profit from small price changes. If the fund's prospectus bars fast trading, permitting some investors to do it is a breach of securities law.
Even if you own a fund where improper trading occurred, so far it appears that the cost to any single fund investor was quite small -- likely less than 1 on the dollar. Your faith in the ethical safeguards at your fund may be justifiably shaken.
But your fund balance should be only marginally affected. And most fund companies have promised to reimburse shareholders.
Lately other scandals have come to light. Morgan Stanley, for one, paid $50 million to settle Securities and Exchange Commission allegations that its brokers steered investors to funds that paid higher commissions. Other firms have been accused of overcharging shareholders who invested large amounts in certain funds.
In addition, regulators are raising questions about the fund industry's longstanding practice of accepting free research reports, computer services or other perks from brokerages in exchange for executing trades through those firms.
Critics charge that these "soft-dollar" deals obscure expenses and in effect get shareholders to pay for things that benefit the fund company. In these areas, though, the potential cost to any single investor is relatively modest -- nothing like the double-digit losses that the bear market inflicted.
What happens if my fund company fails?
Your money is safe. Under the Investment Company Act of 1940, which governs the industry, each fund is set up as an individual corporate entity, with its own board of directors. Essentially, your fund hires the fund company to manage its assets.
If the company were to file for bankruptcy, its creditors would not be able to touch the fund's assets. And the fund's directors could immediately hire a new manager, pending shareholder approval.
Should I sell my fund?
It depends. If the fund is in a tax-sheltered account, where you can shift money at little or no cost, there's a compelling argument for getting out: These companies violated your trust. Moreover, if other investors pull their money out, that may raise the fund's costs and force the portfolio manager to sell stocks to raise cash.
Just as worrisome, the management's legal difficulties may well distract them from their investment duties. Companies such as Strong and Putnam, for instance, are experiencing widespread management upheaval.
If you hold tainted funds in a taxable account, your decision hinges mainly on taxes. If you have a loss in the fund, unloading it will trim your tax bill. But thanks to the bull market, you may have a taxable gain in that fund, and short-term capital gains can be taxed as much as 35 percent. One possible exit strategy is to use a loss in another investment to offset the gains.
Will the government fix all these problems?
Perhaps. At the moment, there are competing efforts to crack down on the industry, including four reform bills in Congress. Among the provisions: more independent directors, a larger role for compliance officers and fuller fee disclosures.
The SEC has put forward its own proposal requiring that all fund trades be completed by 4:00 p.m. (ET) to cut off late trading. Spitzer is forging his own path by demanding lower fees, as he did in the Alliance Capital settlement.
Many of these rule-making efforts may pay off for investors, although it's far from clear what will come to pass. In the end, it seems likely that the industry will focus more on ethics and fiduciary responsibility -- and that's good. More important, fund investors will be far less willing to take the industry on faith -- and that's even better.