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SEC investigates mutual fund cheaters: what it means to an investor

by Tony Novak, CPA, MBA, MT
, revised 11/30/2011

The investment community is facing a new wave of corruption allegations as federal investigators expanded their investigation again this week into the actions of certain mutual fund traders buying and selling funds at other than the fair market price. Some of the biggest names in the financial industry have been named in the SEC investigation including Vanguard Group and Bank of America. Being named in the investigation does not imply any wrongdoing on the part of these firms, but some investment firms are likely to be penalized at the end of the government investigation. Penalties for unfair trading, if assessed, will likely be credited back to the funds for distribution to their shareholders.

Some investors wonder if they can copy these trading strategies for extra profit in mutual funds. Others question whether they should dump their funds due to lack of confidence in the financial markets.

At the heart of the issue is the ability of an investor with “insider” ties to buy or sell mutual fund shares at a better price than an average individual investor and thereby lock in an immediate profit. The investigation alleges that this profit is achieved by taking advantage of technical flaws in the market’s trading systems. Private individual investors pay the price in terms of lost mutual fund gains. Obviously, this can be devastating to the confidence level of the private individual investors. The Securities and Exchange Commission vigorously prosecutes any violations of this basic principle of fair play in the financial markets.

Investors should be aware that there are only two legitimate ways to pay less than another person for mutual fund shares. The first is to buy a large amount of shares; although this is not an option for most of us. Mutual fund companies typically cut fees for investors buying more than a million dollar’s worth of shares. Some companies offer modest discounts for other large purchases. For the rest of us, there is only one way to but cheaper shares or receive a discount on mutual fund fees. Most mutual fund managers waive all or part of their marketing fees when an investor is working with and paying a fee to an independent investment adviser. The lower cost might be plainly visible; for example, the ability to buy a “load” fund on a “no-load” price. In other cases the lower fee is less visible, for example a waiver of surrender charges or internal fees known as “12(b)(1)” charges. The logic is that investors who use their own adviser will be far less expensive for the fund over the long term. Professional advisers handle trades electronically with greater efficiency than the individual fund’s customer support staff.

In general, small investors with less than $10,000 in mutual funds fare better just paying the normal fees charged by the mutual funds. Larger investors will save money over the long run by seeking a non-commissioned independent investor adviser to handle their trades.

There are no legitimate gains to be made by trading funds under any type of timing system or strategy. No one should be allowed to benefit from exploiting the trading system at the expense of other investors. Investors who wait out this storm by just holding onto their funds will likely be rewarded with the long-term gains they expect.

Action checklist for mutual fund owners:

• re-evaluate funds for compatibility with your current investment objectives
• reduce overall risk by balancing market position and investment horizon
• compare the cost of current fund management with other available share classes

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