by Archie M. Richards, Jr.
October 23, 2006

Skullduggery is one reason to avoid actively-managed mutual funds. (Other reasons: Their costs are too high, and they trade too much.) I suggest you concentrate on index funds or exchange-traded funds - especially the latter.

• My first example of misdoing applies to the mutual fund industry as a whole: The published records of funds are exaggerated, because the records of only the surviving funds are included. Assume, for example, that Fund A has had a poor performance and is acquired by Fund B. Fund B has had a good performance and continues to boast about it. Here's the distortion: The record of Fund A simply disappears. To the long-time investors of Fund A, who have suffered a poor performance, the record promulgated by Fund B is a lie. Indeed, the collective records of all actively-managed funds would be significantly lower if the performance of the drop-outs were included. They're not.

• The next wrongdoing is undertaken by individual funds - quite a few of them, I might add: Actively-managed funds, as mentioned, charge high operating costs, well in excess of 1 percent. You'd think the managers would pay for such things as magazines, accounting services, office administration, printers, and entrance fees to industry conferences. No, some of them prefer that you pay, enabling the managers to retain more of the operating charges for themselves. They arrange this by asking brokers to pay the costs and permitting the brokers to charge 5-to-10 times the normal commission rates. These "soft dollars" increase transaction costs, cutting the net returns. In effect, the investors pay normal business costs that the managers themselves should pay. (Unfortunately, the SEC hasn't treated this as a scandal. Like most government regulators, it eventually takes on the point of view of the industry's major companies.)

• Here's another wrongdoing by individual funds: A mutual fund organization starts several funds, but doesn't offer them to the public right away. The investors are private parties, some of whom work for the organization itself. The selection of stocks differs for each fund. A year or two later, the one with the best record is offered to the public, and the others are closed down. The organization boasts about the record of the best fund from the beginning. It doesn't disclose that other funds were started at the same time and were closed because of inferior records. It doesn't say that only with hindsight could the organization know which fund would be best.

• Some funds engage in "style shift." This is made possible by the lack of disclosure by actively-managed mutual funds about what they own between their semi-annual or quarterly reports. Let's say that, according to its prospectus, a fund concentrates on large growth stocks. But for the recent past, large growth stocks have hardly moved, while small value stocks have risen sharply. Therefore, between reporting periods, the fund may sell some of its large growth stocks and buy small value stocks that seem to be rising. Then, before the next financial statement, the fund sells the stocks it's not supposed to own and buys back the ones it's supposed to own. Because of the style shift, the fund has a better record than its competition.

• Some funds restrict the apparent size of their competition. A fund might boast that, among small value mutual funds whose assets ranged from $200 million to $500 million, it had the best record during the 18 months ended September 30, 2006. There are hundreds of small value funds, but restricting the fund size and the time period limits the apparent competition. New investors are attracted by the misleading claims.

• Yet another trick: Just prior to the date of the public statement, the fund buys more of the stocks it already owns. This increases the prices of those stocks, improving the performance for that period.