Some Fixes for a Broken System

Open-end funds have a tragic flaw: The daily fund price, or net asset value, is a myth -- a mere approximation of reality.

The daily liquidity that investors enjoy when buying and selling mutual fund shares at this price is unsound -- real money is trading at a sometimes fictional fund price. (For more on how this works, click here). Acknowledging this Achilles' heel and taking strong steps to protect it are required to maintain the open-end mutual fund as the top choice for mainstream investors.

In the movie The Matrix, revelation came when Neo realized "there is no spoon" -- the utensil was just an artificial construct of the computer program he was in, and could therefore be bent to his advantage over others who played by the rules.

In the same vein, net asset values, or NAVs, are based on prices -- or estimates of prices -- of the portfolio's holdings at a moment in time. With highly liquid larger-cap U.S. stocks, these prices can accurately reflect the true value of the fund's holdings. With illiquid smaller-cap foreign securities, these prices can be off by a country mile. The markets in question may have been closed for hours, or the specific stocks may trade infrequently, as is the case with some emerging-market stocks. Between these two extremes lie various degrees of imperfect fund NAVs.

Like Neo, some investors have noticed the flaws in the NAV calculating programs that run behind the scenes in the mutual fund industrial complex, and they are bending the spoon to their profit. Unlike Neo, they aren't taking this action isn't to the benefit of humanity. NAV arbitrage, or NAV gaming, is a zero-sum game: Every dollar an NAV gamer makes is a dollar lost by ordinary fund investors.

There are currently rules and penalties in place at many funds to cut down on all types of active fund trading, most importantly fund NAV gaming. Sadly, most of the egregious trading violations alleged in various investigations involve fund companies willingly participating for profit in the systematic skimming of their shareholders. These funds enabled NAV gaming by waiving existing rules and fees that were designed to limit the practice.

But even when fund companies do not collaborate with NAV thieves -- and the majority do not -- fund shareholders can still lose: The existing rules and fees do not go far enough to protect long-term investors from a faulty NAV.

Here are some ways to fix a broken fund business by shielding the imperfect NAV from attack.