Rational Investing: Mutual fund practices investigation sure to continue

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

Jimmy the Oracle hasn't been in yet, but with all the negative news in the media about mutual funds, he will be probably be dropping by or calling in the next day or so. In addition to being a chronic malcontent and an "I told you so" who is way too cheap to ever pay for professional help, he also is a secret investor. At least that's what I call him.

I am fairly certain that Jimmy owns several mutual funds, since he has mentioned numerous times that he is diversified. With the mistakes he has made, I doubt that Jimmy has enough left to have a portfolio diversified among a broad spectrum of individual stocks and bonds. As a matter of fact, I would wager that he has several different mutual funds his idea of diversifying. It wouldn't surprise me if they held many of the same issues (the overlap problem I have addressed before).

So, if he does show up and ask me what he should do with his mutual funds in light of the scandals surfacing, what will I tell him?

I will probably tell him he will have to make his own decision about his funds, unless he is willing to spend some money on our reviewing them for him. I will also suggest that he read Wall Street Journal articles on the subject, especially those that appeared the week of Nov. 3-7. That will give him background.

Subsequent to the writing of this column, further in-depth coverage is certain to appear, as the mutual fund industry is a $7-billion-plus repository for much of America's retirement assets.

The industry has been above the furor of the corporate accounting scandals; some fund management companies even sanctimoniously criticized corporate management for legal and moral breeches.

Folks, there's more news to come; more revelations of skullduggery. Next to Al Sharpton, few people love the limelight more than Eliot Spitzer, New York State Attorney General. Who knows what his political ambitions are? Whatever they may be, it is not likely that they will stop with his current position. He has (somewhat gleefully, although his grim demeanor belies it) upstaged the New York Stock Exchange, Securities & Exchange Commission and NASD, formerly known as National Association of Securities Dealers.

So, I will prepare Jimmy for what I believe is coming.

With the lid removed from the Pandora's box of mutual fund practices, Jimmy can expect to read about what happens in the real world of mutual fund investing. In no particular order, what follows are probable additional subjects of further Spitzerization and investigative reporting.

Soft-dollar payments. They're commission dollars used by mutual funds for the avowed purpose of acquiring research from various brokerage firms. This is a "we'll place these trades through you in exchange for timely investment research" arrangement that many times finds research being defined as new computers, software, printers, even rent payments.

Compounding the misuse of the arrangement is the fact that mutual funds may "pay-up" in commissions for those goods and services. That means they are paying above normal commission rates. That comes out of the shareholders' return.

Expense ratios. All mutual funds, whether load or no-load, exchange-traded funds or closed-end funds, have expenses. Expect a major effort to have funds provide shareholders more detailed information on what and how much the expenses are. Management fees, legal fees, marketing costs (referred to as 12b1 fees), accounting charges and who knows what others are coming out of the return of most funds.

We have found that most mutual fund investors have little or no knowledge of what expenses are being charged within their funds. Nor do they have any way of readily knowing how their funds' expenses compare to the average for that category or to other funds of the same type. This will be changing before the brouhaha is over.

In-house funds. Many firms have their own proprietary funds and there's nothing inherently wrong with that. The investigator bunnies' noses twitch, however, when they pick up the scent of higher commissions being paid to brokers on the sale of their in-house mutual funds.

Transaction costs. Not included in the fund's expenses are the transaction costs the commission paid on each purchase or sale of stocks or bonds within the fund. Think about this in terms of the reference above to soft dollars. The more trades there are, the more soft dollars are available for the goods and services that fall under the rubric "soft dollars," and the more internal costs against the asset value of the fund.

Don't misunderstand. I am not here to bash mutual funds. The pros and cons on every one of these points will be hopped on by the authorities and the media. The scope of what you will be reading about in coming weeks is beyond the limits of this column.

Just imagine how long it will take to answer Jimmy's questions.