Fund reform means little to investors


MUTUAL FUND reform may make a lot of lawmakers feel better, but it's not going to change the way investors select funds.

In fact, when the reform process is done, the lawsuits and regulatory cases settled and the industry has been "improved," investors will have a hard time telling the difference. They will know which fund families have tarnished images, but the rest of the process will be unchanged.

That's because current reform proposals are all about improved disclosure, more transparency and reduced backroom dealings. Those are all admirable goals but they don't enter into the ordinary investor's decision to buy a fund.

No matter how much information funds are forced to throw into their prospectuses, most individual investors still won't read them. And no one in the fund world believes they will suddenly get a rash of calls asking for the second part of a fund's prospectus, the one that contains some of the most interesting data, but which only goes to shareholders upon request.

When the headlines fade and the story recedes into the background - and we're months from that point - investors will have to wonder how they are better off, if at all.

Clues for investors

There are some clues for what an investor might do to come away from this episode a better, smarter investor.

If you examine the fund firms involved in the scandals, you can generally point to one of a few flaws in the way they manage money.

In general, their funds have some combination of above-average costs, volatility and portfolio turnover, and average-or-worse long-term results. Their reputation for good management has been in their most-aggressive funds. They are cleaning up their act - eliminating soft-dollar transactions - which is a sign that they may have relied too much on research pushed by brokerage firms.

There are exceptions to those conditions, but you can peg at least one of those problems on each firm touched by the scandal.

Just as you can find some troubling trends with the companies in the soup, so can you find some common ground among companies that are routinely considered to be the industry's best.

"The key for investors is to find a firm where the culture is to put the investor first," says money manager Marc O'Brien of O'Brien Management Inc. in Cambridge, Mass.

"In general, those are the firms that have low expense ratios, low or no 12b-1 fees, that tend to have modest turnover, and that have funds which aim for consistent returns, rather than having the really big year now and then.

"Of the things that are harder for investors to see, the good firms support their managers with a lot of in-house research, and they don't use soft dollars."

Looking for those factors sounds simple enough. But there is a disconnect between having those factors in your selection methodology and actually living by them.

Chasing growth

There are trillions of dollars invested in funds with above-average costs, billions flowing into the hottest funds of the past quarter or year - more than flows into the most consistent funds of the past half-decade - and fortunes going into funds with managers whose turnover numbers make them look like they are chasing growth rather than strategizing to go along for the ride.

If investors are going to benefit from the scandal by being able to choose better funds in the future, they have to do it by adopting a methodology that leads to working with good funds.

Yes, the improved disclosures created by fund reform will help those who take advantage of them. Increased portfolio disclosures will allow firms like Morningstar and Lipper to do more and better research, which might make for a better picture of how funds will perform in the future, but the basics of what investors should look for is not likely to change.

Straight and narrow

By working with a quality firm, rather than throwing money after yesterday's champion, investors will be telling managers that sticking to the straight and narrow is more important than going all-out to top the charts.

In other words, by voting with their feet and consciences - and by sticking to their discipline and not making exceptions to the rules of what they want in a fund family - investors will eventually reform mutual funds one heck of a lot more than regulators ever will.

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