Unfold Mutual Funds' Mountain of Abuses

Either through investment plans at work or through funds purchased directly, most physician-investors own portfolios of mutual funds. Mutual funds have become a big business, and that always invites opportunity for chicanery. The ever-vigilant New York Attorney General Eliot Spitzer is finding widespread abuses in the mutual fund industry that the SEC has ignored. What first seemed to be a molehill has turned into a mountain of abuses.

Garnering Shelf Space

To best attract your attention while shopping, the manufacturer pays for "shelf space," putting the product close to your eye level and not on the bottom shelf, by co-op advertising monies or product discounts. The mutual fund industry is now so overcrowded that it does the same thing to promote its product to buyers. When you ask your account executive for mutual fund recommendations, their goal is to sell you the fund that will put the biggest commission in their pocket.

In mid-November, Morgan Stanley paid a $50-million fine for promoting its own funds and those of other fund groups that paid it large brokerage commissions for "shelf space." Often, brokers sell funds that have huge penalties for early withdrawals or large upfront sales fees, neither of which are particularly good for investors. Those commissions are deducted from the account before your money even has a chance to go to work for you in the fund.

Allocating Performance

In the 1990s, one of the easiest ways to successfully launch a new mutual fund was to pump it full of initial public offerings (IPOs). Large fund families are brokerages' biggest customers, so, when investment banking firms allocate the shares in IPOs to the public, it's no shock that fund groups obtain the largest allocations.

If a multi-billion-dollar mutual fund receives 100,000 shares of a deal that goes from $20 to $50 its first day trading, the impact of that gain is insignificant. On the other hand, if the same 100,000 shares are stuffed into a relatively small $100-million fund within that same fund family, the contribution to performance becomes very significant. A $30 gain on 100,000 shares = $3 million, or a 3% boost to the smaller fund's value.

Late-Trading Flap

Most of the recent press about the mutual fund industry circles around the practice of entering orders to buy or sell a fund late in the day, after the markets have technically closed. The daily value of a mutual fund is determined at the close of business. Orders are supposed to be placed prior to the close, when the final value for the day is unknown. Some fund groups restrict trading once they can identify traders who follow that pattern. The fund manager must either maintain a large cash balance or be able to immediately liquidate holdings to meet redemptions.

If markets are still open in other countries or stocks are trading on the Internet, traders can discern whether the fund is likely to rise or fall in value the following day. More importantly, the in-and-out folks are scalping the fund for a few pennies in value, thereby shortchanging regular investors who buy and hold the fund.

Biggest advantage:

After all the mutual fund industry's scandals, physician-investors may want to consider hiring an investment advisor. You can speak with the individual who is managing your money and build a personal relationship with them. That puts you in the driver's seat, so that your investment goals and objectives are clear and your investments are selected accordingly. Pick a firm whose fee structure is lined up exactly with your own interests, and always understand exactly what you're buying.

Joan E. Lappin is the chairman and chief investment officer of Gramercy Capital in New York, NY. For her 2004 investment ideas, be sure to read the "Investment Roundtable" in the yearend double issue of BusinessWeek. For more information or a tape of her recent appearance on Wall Street Week with Fortune, call 212-935-6909 or e-mail jlappin@gramercycapital.com.