Alan Reynolds

Mutual funds are suffering the glare of regulators' high beams because some sharpies trade the funds too quickly ("market timing") or after regular business hours ("late trading"). Even The Washington Post's most astute financial writer, James Glassman, was swept up in the excitement. He wrote: "The mutual fund scandals are spreading. New revelations show that more and more managers betrayed the mass of their customers by illegally favoring a few fast-buck artists."

Actually, what may have been done "illegally" remains unclear. New York allows "deception, misrepresentation, concealment, suppression, false pretense, false promise" and perhaps an evil grin to be prosecuted as fraud, regardless of intent. But most of Glassman's readers probably take "illegally" to mean a provable criminal offense under federal law.

Late trading at the previous day's price violates a 1968 SEC regulation. But a regulatory edict is not a law, and the SEC deals only with civil sanctions, not crime. Market timing is not even a civil offense, although one case involves fund managers themselves, which might qualify as insider trading. As for the mutual fund companies themselves, most allegations of impropriety concern the fact that their sales literature implies that fund managers "may" -- at their discretion -- attempt to thwart frequent traders. Failure to thwart frequent trades may therefore lose customers, which could hurt the stock price of affected mutual funds companies.

From a mutual fund investor's point of view, however, neither the fund's redemptions nor its legal bills have any impact on the value of the mutual funds themselves. The value of a mutual fund depends only on the value of stocks in the fund. So why dump a mutual fund because of "scandals" unless you have a better investment alternative?

Glassman noted that Morningstar, which rates the mutual funds, has nonetheless recommended that investors shun all funds that are accused of something or other. That has to be Morningstar's worst recommendation of all time. Glassman himself advised: "If you own good funds that are under scrutiny by the authorities, hold on to them for now, until more facts come to light. But if the funds are marginal performers, dump them. ... Even if the shenanigans prove isolated, however, this is a good time to consider alternatives to conventional mutual funds. The best choices fall under the broad rubric ‘exchange-traded funds,' or ETFs."

Alan Reynolds

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