What to Do with Scandal-Tainted Funds

These are trying times for fund investors. Every few days the market-timing/late-trading scandal ensnares a different fund company, raising new issues and sparking new debates. Figuring out how to react is not an easy task. The big question: If I own a mutual fund from one of the scandal-tainted shops, what should I do?

Below, we address some of the key factors to consider in your decision.

What does Morningstar mean when it says ‘consider selling’?
We think the firms thus far implicated in the scandal have demonstrated an egregious breach of their fiduciary responsibilities. That's why we currently have five firms on our "consider selling" list: Bank of America’s Nations Funds, Bank One, Janus, Strong, and Alger. Given the kind of behavior that evidently went on at these firms, we don’t think they clear the minimum threshold for corporate governance.

Some news reports have equated that to a flat-out "sell" recommendation, but that’s not accurate. We think the problems at these firms are serious enough that they no longer offer an attractive risk/reward proposition. However, that doesn’t mean everyone should sell.

In fact, one of the things that makes funds so appealing is that there's rarely a need to rush out and sell, because one piece of bad news isn't going to hammer your investment the way it might a stock. Furthermore, the industry is being forced to clean up its act, meaning that funds are apt to be better regulated and more shareholder-friendly in the future than they are right now.

That's why it pays to take stock of your personal situation--and the options available to you--before deciding whether to move your money.

What are my other options?
If you invest in funds through a supermarket like Schwab or through an advisor who offers funds from a number of companies, then you should be able to find plenty of good replacements.

On the other hand, if you have limited options because you hold a fund from one of the scandal-plagued shops in a 401(k) or 529 plan, it’s probably a good idea to hold on. For example, if  One Group Bond A (PGBOX) were the only bond fund in your 401(k) plan, it wouldn’t be a good idea to drop your desired fixed-income exposure solely on the basis of news about trading transgressions at the firm.

How can I find the most shareholder-friendly companies?
There has been a lot of discussion of the dilemma investors face in moving money to another firm given the risk that that firm, too, could be ensnared in the investigation. To be sure, there are no guarantees that any firm won’t get caught up in this mess. However, it’s not hard to find a firm with a strong record of putting fundholders first. Though even these firms could have an individual employee that causes trouble, their track record suggests the sort of systematic wrongdoing uncovered by Spitzer is extremely unlikely to occur. Remember that our main concern with the inappropriate actions such as late trading is what it says about a firm’s culture and compliance rather than the act itself.

So, look for a firm that leads the way in the quality and corporate governance measures and you’ll be able to sleep at night. You can find big companies like American, Vanguard, T. Rowe Price, and Fidelity that have done an outstanding job in most or all of the criteria. Likewise, you can find smaller firms such as Dodge & Cox, Longleaf Partners, and Davis/Selected that have closely aligned their interests with shareholders'. This is by no means an exhaustive list of those with the highest standards.

What we mean when we say limit investment or hold off on new investment
We’ve recommended limiting investments in Putnam and AllianceBernstein. By this we mean that these are firms that have some serious issues to tackle both in terms of ethics and quality of management. Thus, you wouldn’t want a big part of your nest egg riding on these firms' funds. In addition, we’d be selective in choosing funds from these firms because most are mediocre or worse.

What are the costs of selling (and buying a new fund)?
If you do have other good options, the second step is to examine the costs associated with selling. The bear market wiped out most capital gains that fund investors had, but some may be holding fund shares from the mid-1990s that would trigger capital gains taxes if they were sold. Many investors have booked capital losses they could use to offset these gains, however. In any case, be sure to evaluate your tax situation so that you don’t get hit with a bill come April. Additionally, switching from one load fund company to another could mean paying an additional load. If so, it’s probably wise to hold tight and wait until the dust settles before you take such a hit to your portfolio.

How much of my portfolio is tied up with a 'scandal shop'?
Once you've examined the tax and transaction costs associated with the selling, take a look at how much of your portfolio is entrusted to the firm in question. If you’ve got more than half your assets with a firm that we have in our "consider selling" or "limit investments" bin, then it’s a good idea to scale back if possible.

How will restitution work?
It's unclear how much these practices cost fund investors (some have put the damages in the $1 billion range) and how fund firms will go about paying back investors. Although most firms implicated in trading abuses thus far have said they'll make restitution to shareholders, they haven't clarified whether they'll make payments to current shareholders or those aboard the funds at the time the trading abuses went on.