After scandals, a green light for investors

Mutual-fund industry executives breathed a collective sigh of relief as 2004 rolled to a close. Investments in their $7.9 trillion industry were up for the year, despite the numerous scandals over the past 16 months.

"We clearly have weathered the storm successfully," says Paul Schott Stevens, president of the Investment Company Institute (ICI), the industry's primary trade group.

Net new investment in 2004, excluding money-market funds, probably reached or topped the level of any of the past five years, he estimates. Even critics figure that the industry has been purified to some degree.

So can you invest in funds with confidence? Yes, mutual-fund experts say. Investors, though, should still watch out for excessive fees. Such costs aren't always clearly spelled out early in the sales process.

"Mutual funds, for the vast majority of Americans, are the best place to invest," says James Glassman, a fellow at the American Enterprise Institute in Washington. "Right now, the mutual-fund industry is in very good shape. Funds really got the message."

The message was tough. In 2003, New York Attorney General Eliot Spitzer began probing the fund industry for trading abuses. What he found was that some funds had cheated their long-term customers by giving special deals to hedge funds and other large clients, allowing short-term trades. Some 20 funds agreed to pay penalties of more than $2.5 billion, nearly all going back to mutual-fund investors. These funds also lost tens of billions in assets under management as shareholders bailed out in disgust.

Mr. Spitzer's revelations shook up an industry that had enjoyed a good reputation for integrity. Just as important, they prompted the Securities and Exchange Commission, the financial industry's primary national watchdog, to initiate new rules aimed at preventing future abuses.

"The mutual-fund investor is better off as a result of what the SEC has done," says Barbara Roper, an expert at the Consumer Federation of America. The SEC deserves credit for doing even more in addressing the scandals than it had to do just to save face.

But Ms. Roper would like the SEC to do more. In particular, she would like the commission to require mutual funds to disclose more information during sales talks about fund operating costs, distribution costs, and the potential conflicts of interest that salespeople might have in pushing a particular fund. The cost to shareholders of inadequate information on fund expenses, she points out, can be much more than the relatively small losses - per shareholder - from the "late trading" or "market timing" abuses that Spitzer found.

Last month, her organization - as well as the AARP, Consumer Action, Consumers Union, and Fund Democracy Inc. - wrote to the SEC, suggesting details for "point-of-sale" disclosure.

The SEC already has approved a new rule on disclosure of fund policy on late trading and market timing. It is expected to decide soon whether to prohibit past-4 p.m. trading and on requiring a share redemption fee of 2 percent on the sale of fund shares within five days of the original investment - a policy to discourage market timing.

Despite such rules, and more aimed at stricter fund governance and rule compliance, some critics suspect that mutual funds will revert to former practices without aggressive enforcement.

The SEC "took its eye off the ball in 2004," says Andrew Clark, an analyst with Lipper, a Reuters company that tracks and analyzes mutual funds. In order to protect investors, it should be "in the face" of mutual funds with regular audits to see that they are adhering to the law and their fiduciary duties. Moreover, he says, funds should have their own outside auditors reporting directly to their boards any findings about violations of trading rules, such as illegal trading of shares after the 4 p.m. stock market closing, or unethical rapid trading of shares.

Banks can expect regular audits by their regulators. So should mutual funds, Mr. Clark says. Their shares are owned by 54 million American households. and if President Bush manages to win partial privatization of Social Security, even more Americans will be invested in funds. Clark, however, doubts that either Congress or President Bush will want to give the SEC the necessary financial resources to tackle regular audits of the nation's 8,000 funds.

The industry's reputation was helped by a good investment performance in 2004. On average, diversified US stock-fund shares were up 12 percent, Lipper says.

A survey last fall commissioned by the ICI found that 72 percent of shareholders had a "somewhat" or "very" favorable impression of mutual funds. That's down from 84 percent in 2000, the peak of the bull market.

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