No investment is perfect.
Real estate has down cycles, gold gyrates wildly, stock markets crash, antiques and collectibles go out of favor, bonds are racked by interest rate moves, and annuities carry hefty fees.
Investors know this in their hearts, yet hope against hope that investment perfection can be found.
Recent revelations that prominent mutual fund companies cut deals with deep-pocketed clients shouldn't come as a total surprise, knowing human nature. For example, they permitted them to move in and out of funds quickly to take advantage of various time zones and trading abnormalities while average investors were left to play "buy and hold."
The amount of money involved and damage to shareholders isn't the key issue. What is unsettling is that it occurred in an industry with an image of treating all mutual fund shareholders equally. This breach of faith will trigger greater scrutiny and regulation of fund practices.
For example, law requires that investors who buy mutual funds after 4 p.m. pay the next day's price. However, at least one wealthy investor was permitted to buy mutual fund shares after major market announcements had been set and before the news came out.
"It shakes the foundation of an industry that has generally been considered clean," said John Markese, president of the American Association of Individual Investors; www.aaii.com, in Chicago. "It's shocking that this was allowed to take place, since who wouldn't want to buy on tomorrow's news with today's prices?"
There's a need for internal auditing so no one receives special treatment, said Markese.
The mutual fund was long revered as the white knight of investment. It featured diversification, and ease of entry and exit. And its management championed the little guy investor. Inevitably, its armor began to tarnish. Many funds did poorly not only because of market traumas but also because of bad management. Some portfolio managers bet big on sectors or countries without informing investors.
Most troubling has been the fund industry's sneaky habit of tacking on a multitude of confusing fees not easily detected by the army of 95 million shareholders. Fund fees keep increasing, and some fund families focus marketing on lax investors who disregard costs.
Looking at the recent scandal, tens of millions of dollars in profit was derived from improper trading at the expense of individuals.
New York Attorney General Eliot Spitzer, now joined by the U.S. Attorney's Office and Securities and Exchange Commission, charged that hedge fund manager Canary Investment Management arranged with prominent mutual fund companies to improperly trade their fund shares.
Canary, without admitting or denying wrongdoing, is paying a $10 million fine and $30 million in restitution. The mutual fund companies involved are Bank of America's Nations Funds, Bank One Corp.'s Banc One, Janus Capital and Strong Capital, and Spitzer has subpoenaed a raft of additional funds and securities firms.
"The potential downside is that people may say, 'I'm fed up with investing because you can't trust anybody, so I'll keep it in the bank,' " said Don Cassidy, senior research analyst with Lipper Analytical Services in Denver. "But because the stock market has been rallying for a year, people are less likely to dump funds than during 2001 or 2002 when the market was down and problems at Enron and WorldCom were on everyone's minds."
Just as company officers sign audit statements, they should be required to give frequent certification to the SEC about their trading practices, says Cassidy.
"There's a need for stronger compliance measures and for the funds' boards of directors to become more active in fighting for their investors," said Russel Kinnel, director of fund analysis for Morningstar Inc. in Chicago. "Recent events will lead to greater regulation, since the SEC in the past was encouraged by the fund industry to say, 'Oh, too much disclosure and information is just going to confuse the poor little fund investor!' "
No average investor could have known about the Canary shenanigans. However, an investor who chooses a fund firm with a strong record of capably handling shareholder money and treating investors like owners should feel comfortable, Kinnel believes.
But if a fund is charging more than 1.5 percent in annual expenses for a stock fund or 1 percent for a bond fund, it's running that fund for its own gain, not yours, he warned. Watch out for fund companies that "merge away" weaker funds into other funds to cover up past mistakes. In addition, if a fund company launches funds based on quirky themes to grab quick assets, that's a warning sign.
On the positive side, examples of mutual fund companies that do offer a number of worthy low-cost funds include Fidelity Investments, Vanguard Group, T. Rowe Price, American Funds, Dodge & Cox and Harbor, he said.
The fund industry maintains that it favors strong medicine in reaction to the recent embarrassment. "We must make sure regulators have time and resources to arrive at an accurate diagnosis so that they can prescribe treatment," said Chris Wloszczyna, spokesman for the Investment Company Institute in Washington, D.C.
But some tarnish on the white knight's armor may be impossible to scrub off.
Andrew Leckey answers questions only through the column. Address questions to Andrew Leckey, "Successful Investing," P.M.B. 184, 369-B Third St., San Rafael, Calif. 94901-3581, or by e-mail at email@example.com.