Originally published in the Sunday, February 29th edition of the Minneapolis - St. Paul Star Tribune.

For decades, the mutual fund industry enjoyed an excellent reputation untouched by the kinds of corporate scandals that led to the bankruptcy of Enron, the indictment and demise of Arthur Andersen, and the adoption of the Sarbanes-Oxley Act.

This halcyon period ended dramatically in September with the Canary Capital case and subsequent developments. Investors were shocked to learn that some mutual fund clients were allowed to invest "late" in a fund, which is equivalent to betting on a horse race after it is over.

Investors were dismayed to learn that other fund investors (including Richard Strong, the founder of the Milwaukee-based Strong Funds) were allowed to "market time" fund investments at the expense of long-term fund investors.

Investors became aware of other abuses as the spotlight turned on the fund industry. Some managers supplied lists of portfolio holdings to favored clientele, so they could profit on such "inside" information.

Some fund distributors erroneously calculated sales charges, so that investors did not receive "break points" on sales loads to which they were entitled. Other investors were encouraged by fund distributors to buy share classes with unjustifiably high costs.

In the past four months, the industry has received more unfavorable publicity than it got in the preceding six decades. The industry has been scrutinized intensely scrutiny by the media. The Securities and Exchange Commission (SEC), the National Association of Securities Dealers, state attorneys general and state securities commissions all have launched investigations. Meanwhile, the SEC and Congress are considering changes in regulation and the law. Such proposals have even found their way into the presidential race.

With this drumbeat of bad news, the typical investor might reasonably ask -- should I continue to invest in mutual funds?

The answer is a resounding "yes."

While the late trading and "market timing" violations revealed a serious breach of trust by a few insiders, the vast majority of personnel and funds have been untouched by these scandals.

The negative dollar impact of the "market timing" practices has been estimated at about $4 billion. This is not chump change, but it is dwarfed by the $7 trillion fund industry, and by the amounts at stake everyday in the stock and bond markets. (The meltdown of Enron alone caused the disappearance of $100 billion of market value.)

Several affected fund groups already have announced plans to reimburse shareholders who were hurt by these practices. Alliance Capital entered into a settlement agreement under which fund fees will be reduced by 20 percent for five years, and the MFS funds have entered into a tentative agreement to cut management fees $125 million over the next five years.

Sunshine disinfects

It has been observed that "sunlight is a great disinfectant." In response to the well-publicized scandals and enhanced scrutiny, even before the adoption of new SEC rules and new laws, fund groups are carefully scrutinizing their practices and those of financial intermediaries, to make sure there is no late trading or inappropriate market timing. Fund distributors are enhancing their procedures so that shareholders invest in appropriate classes and receive deserved sales load discounts.

In short, while important details of regulatory reform are unresolved, the mutual fund industry has already to a large extent "cleaned up its act."

Insiders found guilty of illegal acts or egregious judgment have gone to jail, lost their jobs or been removed from fund involvement. Fund directors are asking harder questions of management. With the battering that some fund groups have received from regulators and the media (and the consequent loss of large investors such as retirement plans), fund management companies have learned that a highly effective compliance function is indispensable from both an ethical and "bottom line" standpoint.

The one SEC proposal already adopted requires that funds have a chief compliance officer, who must be hired by, and whose compensation must be set by, the independent fund directors. Funds must adopt compliance procedures to prevent funds and their service providers (advisers and distributors) from violating securities laws. With the chief compliance officer reporting directly to fund directors, the fund compliance process will be more robust.

The SEC has also proposed rules requiring that:

  • 75% of fund directors be independent.
  • Fund boards have a chair who is independent of management.
  • Fund boards perform an annual self-evaluation of their effectiveness, including consideration of the number of funds they oversee and the board's committee structure.
  • Independent directors meet in a separate session at least quarterly without the presence of fund management.
  • Independent directors be authorized to retain their own staff to help them fulfill their fiduciary duties.
  • Purchasers of fund shares receive the current day's price only if the fund, its designated transfer agent or a registered securities clearing agency receives the order by 4 p.m. Eastern time. This so-called "hard close" would eliminate the possibility of illegal late trading of fund shares by intermediaries.

Blizzard of reform

Additional SEC action is likely to improve disclosure of mutual fund transaction costs (e.g., portfolio turnover and brokerage commissions); revenue sharing and "soft dollars" practices; fund policies used to prevent market timing; fund policies regarding disclosure of portfolio holdings, and fund policies regarding the use of "fair value" pricing, which has the effect of discouraging "market timing."

Additional reform legislation is likely to be enacted by Congress. Sen. Joe Lieberman, D-Conn., is a sponsor of the "Mutual Fund Transparency Act of 2003" and Sen. John Kerry, D-Mass., introduced the "Mutual Fund Investor Protection Act."

In November the House overwhelmingly passed the "Mutual Funds Integrity and Fee Transparency Act of 2003." With the bewildering blizzard of proposed reforms emanating from the SEC and Congress, it is too early to speculate on the likelihood of any particular legislation being adopted, or on the exact provisions of new SEC rules.

But the typical fund investor can take comfort from the fact that most funds and fund personnel were untouched by the well-publicized scandals, and that the industry's "bad apples" are gone.

The typical fund investor should not dwell unduly on the details of new rules and laws. Investors should focus on the importance of maintaining an informed, rational and disciplined investment approach that embraces principles such as diversification and reasonable cost.