Rational Investing: Investors should take note of mutual fund hijinks

Clark Davis is a 34-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.

Ah, the benefits of the media coverage of Martha Stewart, Jeffrey Skilling and other high-profile wrongdoers: at least in the eyes of those in the mutual fund industry. Evidently the SEC and various state attorneys general putting the industry under the magnifying glass is not front-page news, but relegated to the business section at best and inside pages most often.

The Democratic primaries and all the candidates' allegations further help to keep relatively unnoticed the investigations into mutual fund practices.

Please don't get me wrong. This is not about bashing mutual funds. It's about bringing to investors' attention some of the facts many are not aware of, some of which are included in the prospectus that legalese-loaded document that the law requires be given to every purchaser of funds, but which is seldom, if ever, actually read.

So, let's take a look at explanations of some of the areas into which the authorities are delving.

Soft dollars. Although the expression is sometimes seen in the press in stories about campaign contributions, in the investment business it refers to brokerage commission dollars that are used to acquire research.

Unfortunately, over the years the definition often used by money managers at funds and institutions has been expanded to cover a wide range of expenses. Is "research" a computer or copy paper or a trip to the West Coast?

One would not think so, but these items, as well as some that are even bigger stretches, such as rent, tickets to ball games and multiple martini dinners, have found their way into the category of research expense.

Regulatory changes have been proposed that will seriously narrow that definition. The SEC is also concerned because current rules allow brokers that provide "research" in exchange for commissions to charge rates above their lowest rates for such transactions.

Obviously a potential conflict of interest rears its head. The more the management company trades, the greater the dollar amount available for the "research" goodies. And where do those extra commission expenses come from? Yep, the investors' portfolios.

This next one is not used by all funds, but you will be hearing about it with increasing frequency as the SEC proposals move through the pipeline. Called a 12(b)1 fee, its use was approved in 1980 as a way for new and/or small mutual funds to cover marketing expenses. The fee generally ranges between 0.25 percent and 1 percent, varying by mutual fund company. Interestingly, it is still being charged by some funds that aren't open to new clients, as well as by funds with over a billion dollars under management hardly the definition of small.

Typically the 12(b)1 fee is paid to the brokerage firm that sells the fund. Where does it come from? You guessed it the investors' assets.

So what's a measly percentage point in the scheme of things? At the end of 20 years, an investment of $10,000 at 8 percent would be worth $46,610. At 7 percent it would be worth $38,697 a difference of $7,913. Measly? I think not.

Will the new regulations eliminate this fee? I wouldn't bet on it. Expect the industry to lobby hard against change, since these fees totaled approximately $9.5 billion in 2001.

You'll also be hearing about a practice that is not disclosed in the sales literature: mutual funds "buying shelf space." There are brokerage firms that place certain mutual funds on their preferred or select list for a fee. The salesperson's commission is usually higher for selling these select list funds, which creates a situation in which a salesperson's objectivity could be called into question.

What does all this mean to you? Talk with your financial consultant about these issues. Ask questions. A true professional will give you straight answers. He will tell you how he is compensated and explain what services he provides for that compensation. He should also help you evaluate investment choices when it comes to mutual funds or separate managed money accounts. If that is not the case, look for another source of financial help.

There are a lot of good, well-trained financial professionals out there; there's no reason to stay with one who isn't.