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Do We Really Need Another Reason Not To Buy Mutual Funds?

George C. Fisher

"It's such a simple concept: a mutual fund is a company that pools the money of many investors -- its shareholders -- to invest in a variety of different securities. Investments may be in stocks, bonds, money market securities or some combination of these. Those securities are professionally managed on behalf of the shareholders, and each investor holds a pro rata share of the portfolio -- entitled to any profits when the securities are sold, but subject to any losses in value as well." - Mutual Fund Education Alliance, a not-for-profit trade association of the no-load mutual fund industry.

The key words here are "on behalf of the shareholders" and I believe that many actions taken by actively managed mutual funds are not in the best interest of its shareholders. Fund fees, mutual fund director pay raises and phantom capital gains exposure have been favorite topics of mine, both in these commentaries and in my books. I think the latest round of scandals concerning mutual funds puts to shame the concept of "on behalf of shareholders".

As a brief refresher course, all mutual fund purchases and sales are between the investor and the fund, not between investors as with stocks. The price of the trade is established as the net asset value (NAV) of the fund as of the close of the trading day, which is 4 pm east coast time. Trading in mutual funds after hours is illegal under New York's Martin Act and a violation of SEC rules because an investor can take advantage of announcements made after the market close involving the fund's investments.

It seems, according to Eliot Spitzer, Attorney General for New York, Janus, Strong, Bank One and Bank America allowed a hedge fund, Canary Capital Partners, to trade after hours at that day's closing price rather than the following day's closing NAV as required by law. Canary Capital could benefit from any good post-close news, such as unexpected earnings news, buying at yesterday's NAV and selling at tomorrow's NAV. According to Spitzer, "It was like betting on a horse race after the horses have crossed the finish line."

The mutual funds furthermore allegedly allowed Canary Capital on-line access to their latest portfolio positions. Unlike individual investors who have to wait for quarterly reports to explain position changes, Canary Capital had immediate access to current fund positions, allowing them to better evaluate fund assets plumb for illegal after-hours purchase or sale.

How were every-day small investors hurt? Canary enjoyed advantages that small investors didn't. Even worse, huge movements of money in and out of a fund make it difficult to manage and could force a fund to sell stocks the manager would prefer to keep. That hurts returns. Additionally, the after-hours illegal trading scheme defrauded other investors in funds by strapping them with additional trading fees that also hurt total return and illegally gave Canary Capital a material gain. Most every mutual fund prospectus discourages short-term trading in their funds for these exact reasons. Some even imply they are vigilent against such in-and-out trading. However, their pledge to the small investor did not stop them from cozying up with Canary Capital's trading scheme.

While not admitting any wrong doing, Canary Partners agreed to pay a $40 million fine imposed by Spitzer.

Now we can add illegal trading to the list of reasons not to buy an actively managed mutual fund, as if we really needed another rationale. Build your own personal mutual fund using DRIPs and forget about annual management fees, excessive pay raises, phantom taxes and illegal trading.

George Fisher, author of The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002) and All About DRIPs and DSPs (McGraw Hill, 2001), Sagamore Beach, MA [email protected]

Copyright North Shore Associates 2003