What Really Needs Fixing in the Mutual Fund Mess By chasing the scandal du jour, regulators have missed the industry's most serious faults. Here's what the fund cops should be after--and what you should be avoiding.
By Paul J. Lim

(Business 2.0) – So what's next? Before investing in a mutual fund, should you inspect it for termites? Every week seems to expose some new evidence of ethical dry rot in the fund industry--and every other week, some congressperson or industry regulator reveals a high-minded new plan to outlaw selective market timing or late trades.

Such reforms, however, merely plaster over deeper cracks in the foundation. "There are serious problems in the way the industry balances its motives against shareholder interests," says Steve Savage, a managing director with Litman/Gregory Asset Management, based in Orinda, Calif. Funds that impose excessive fees or countenance subpar performance cost shareholders more than all the market timing and late trades ever committed. Still, the current scandal has put regulators in a fix-it mood. Now would be a perfect time to give the $7 trillion industry the thorough renovation it needs. Here we suggest some places to start.

One note: Until the changes happen, you're going to have to police your own fund portfolio. In this rising market, both ethical and unethical funds have made money. No matter. There's no reason to ever bother with funds that fail to put your interests first.

REFORM 1: Make the fund directors do their job. Most investors assume that their funds are owned by the institution that created them--that the Janus fund, say, belongs to Janus Capital Group the way Crest belongs to Procter & Gamble. Not true. As a legal matter, funds are independent corporations. Janus's board of directors is supposed to negotiate with Janus Capital to get the lowest fees and best performance. If the board isn't satisfied, it has the power to take the fund's business elsewhere.

In reality, of course, few boards have ever dreamed of exercising that power. In some cases, directors are pals or former colleagues of the managers; in other cases, directors sit on the boards of dozens of funds run by the same sponsor and are beholden to the sponsor for a six-figure paycheck--not counting retirement benefits. Even the least conflicted board has a hard time siding with a mass of anonymous shareholders against fund managers they meet with regularly. "It's like the Stockholm syndrome," says Don Phillips, managing director of Morningstar, the fund research outfit. "Directors spend so much time with the managers that they begin to think like them."

Some regulators want to require that 75 percent of board members be "independent"--that is, free of any ties to the sponsor. Others suggest requiring that the board chairperson, at least, be independent. But neither guarantees vigilance. Putnam funds, for example, have long had both a majority of independent directors and an independent chairman. That didn't stop watchdogs at the Securities and Exchange Commission, however, from accusing Putnam employees of market timing.

Mercer Bullard, president of consumer advocacy group Fund Democracy, thinks a better solution is for the SEC to go after fund directors with as much vigor as it uses to pursue fund executives. "Unless directors are personally held accountable for shareholder interests, we won't see meaningful protections," he says. Morningstar's Phillips suggests forcing directors to write an annual letter to shareholders outlining what they did or didn't do to lower fees or improve performance. Such a rule might shame even unindicted directors into becoming more vigorous watchdogs.

In the meantime, the only real indication of a board's effectiveness is the fund's behavior. Has it held fees below the average for funds of its type? Does it close the fund--stop accepting money from new investors--when the managers can't find attractive investments or when the fund gets too large to invest? By these measures, says Tim Schlindwein, a fund consultant and former chairman of fund company Stein Roe & Farnham, some of the best-led fund companies include Ariel, Dodge & Cox, Harbor, and Vanguard. (For a comparison of the largest fund families, see "Does Your Fund Family Treat You Right?")

REFORM 2: While you're cracking down on fees, don't miss these. For months, New York attorney general Eliot Spitzer has said that advisory fees, the 0.25 to 1.5 percent slice of assets that managers receive annually for investing a fund's money, are excessive. Many fund advocates agree, but they get even more exercised over so-called 12b-1 fees. About two-thirds of all funds levy these charges (which can run as high as 1 percent a year) to defray the costs of marketing funds to future customers. (Imagine forcing Explorer owners to pay Ford $300 a year so the automaker could advertise SUVs, and you've got the picture.) In adopting rule 12b-1 in 1980, the SEC assumed that many fund directors would eliminate these marketing fees once their funds reached a certain size. They didn't. In fact, more than 150 funds that are closed to new investors still charge the fees.

The fund cops should also investigate the setting of transfer agency fees. This little-noted administrative charge runs about 0.18 percent of assets today. Curiously, the average is nearly 50 percent higher (0.26 percent) in the largest domestic equity mutual funds, where you'd expect economies of scale to lower costs. Jeffrey Keil, vice president for global fiduciary review at Lipper, a New York fund-tracking organization, has an explanation. He notes that large fund firms tend to assign their own in-house transfer agencies to handle the work. No competitive bidding equals higher fees.

Ken Gregory, president of Litman/Gregory, does not believe that regulators should get into the business of setting any fund fees. But he argues that directors could do a far better job negotiating the transfer agency charge. Like Phillips, he thinks disclosure might be the cudgel to beat directors into line. Suppose each fund was required to state in its prospectus how its administrative expenses compared with the industry average? Alongside that comparison would be a statement from directors explaining why they were asking their shareholders to pay more.

REFORM 3: Cure fund obesity. Management companies like to see funds grow because their fees grow with them. Shareholders, on the other hand, should prefer funds that stay small, because such funds are easier to invest successfully. "This may be the biggest conflict of interest in the industry," Gregory says.

Size affects large-cap funds and small-cap funds differently. The former tend to trade shares in huge blocks; the bigger and more unwieldy the trade, the higher the transaction costs. Total transaction costs might eat up 0.66 percent of a typical 500,000-share trade, for example, but 1.33 percent of a trade involving 1 million shares. Oversize small-cap funds, on the other hand, find it difficult to put all their money to work in companies with relatively few shares on the market. They frequently end up buying less promising companies. Theodore Aronson, a managing principal at Philadelphia money manager Aronson & Johnson & Ortiz, has a simple solution to fund bloat: compensating managers on performance relative to a benchmark. "If they were getting paid on performance rather than assets," he says, "maybe firms would close funds sooner."

Until directors and regulators start to push funds in the right direction, you can cast a vote for reform with your feet. A fund's asset size and total expenses--including 12b-1 and management fees--are readily available online at sites such as Morningstar.com and Yahoo Finance. In general, stay away from international stock funds with expenses that come to more than 1.5 percent of assets and domestic stock funds with expenses over 1 percent (1.5 percent for small-cap funds). Similarly, steer clear of small-cap funds with more than $1 billion in assets--they'll be at a disadvantage putting money to work against nimbler competitors. Before investing, you should also call the company and ask for its policy on fund closings. Families like Wasatch and Bridgeway have a history of turning away investment dollars when their funds get too big. By doing so, they're putting the interests of shareholders ahead of their own. But then, they're fiduciaries; they're supposed to act that way. Too bad so few funds remember to.

Paul J. Lim is a senior editor at U.S. News & World Report.