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Are Mutual Funds Safe Investments?

NEW YORK ( TheStreet) -- As more details of the Bernie Madoff investment scandal unfold, plenty of investors feel panicked. After all, if the fat cats were robbed by hedge funds, how can the average investor protect a small account from fraud?

The safest approach is to tuck cash into banks and Treasury bills, but there is another option: mutual funds.

The funds have come through the downturn with their reputation for transparency intact. While Congress is planning investigations of brokers and hedge funds, there are few calls to reform mutual funds. At a time when Lehman Brothers and Bear Stearns have collapsed, major fund companies -- such as Vanguard and T. Rowe Price (TROW - Get Report) -- remain on sound footing.

To be sure, most funds have suffered sizable losses during the past year. But patient shareholders are likely to recover as the economy revives. That is very different from the thousands of Madoff investors who have lost everything.

This is not the first time that mutual funds have navigated a downturn without suffering a scandal. During the difficult years of 1974, 1987 and 2000, investors faced losses, but there were no cases of major funds robbing shareholders.

Can mutual funds survive a full-blown depression without being tarnished? Some already have. Consider American Funds Investment Company of America (AIVSX), which started in 1934 and is still going strong. During the past 15 years, the fund has returned 7.4% annually, outperforming 81% of large value competitors and beating the S&P 500 by a percentage point, according to Morningstar.

Other Depression survivors that have stayed out of trouble and beaten the S&P 500 during the last 15 years include Fidelity Fund (FFIDX), which was founded 1930, and Pioneer Fund (PIODX), founded in 1928.

The fund industry's success can be traced to Depression-era legislation, which established guidelines that remain in place. Under the rules, funds must disclose their fees and holdings. Share prices must be published every day.

The contrast with hedge funds is stark. While mutual funds must keep open books, hedge funds can labor in secret, providing only minimal disclosures to investors. The rules limit how much mutual funds can charge, but hedge funds can take whatever the market will bear.

Faced with client defections, some hedge funds have been backpedaling lately, chopping fees. But many managers still take 20% of profits and annual expenses of 2% or more. Mutual funds take none of the profits, and many charge annual expense ratios of 1% or less.

Perhaps the most important rules recently are ones that limit the amount of leverage that mutual funds can use. While typical mutual funds pay cash for their investments, hedge funds often trumpet their ability to borrow as much as they can. During the bull market, leverage goosed returns, but it proved disastrous when markets collapsed.

Besides leverage, mutual funds are limited in the amount of short selling and other strategies that they can employ. Funds cannot invest in the kind of complicated options trading that Madoff pretended to use.

The last time mutual funds were accused of massive wrongdoing came in 2003 when former New York Attorney General Eliot Spitzer launched a crusade, claiming that companies had stolen billions of dollars from their shareholders. Reading the charges, some commentators concluded that mutual funds were a cesspool of corruption. In fact, the case proved how clean most funds are.

Spitzer accused the funds of permitting favored shareholders to trade rapidly in and out of portfolios, a practice sometimes called market timing. He made headlines for a few months -- and then the scandal disappeared from the front pages.

New York tried a few cases, and didn't win any. No new laws were passed, because none was needed. Instead of howling about lost savings, most shareholders ignored the fuss and proceeded to pour hundreds of billions of dollars into mutual funds in the next few years.

To find out exactly how much shareholders had lost, Spitzer required accused fund companies to hire outside consultants. But no one could figure out if the rapid trading had actually cost shareholders anything.

For example, Putnam hired Peter Tufano, a distinguished Harvard Business School professor, who estimated that the rapid trading might have directly cost shareholders a few million dollars out of the total $250 billion managed by the company. In his final report, the professor acknowledged that his estimate could be wrong. It was even possible that the rapid trading benefitted shareholders generally.

Because of the uncertainty surrounding rapid trading, fund companies should never have allowed it. But instead of calling press conferences, Spitzer could have handled the issue by making a few phone calls.

Once the issue became public, companies installed technology to pinpoint instances of questionable trading. By all accounts, rapid trading quickly disappeared and now no longer poses a problem.

The incident confirmed again that most fund companies are honest. For decades, these transparent businesses have shown that they can adjust to changing conditions and enable retail investors to build sound portfolios.

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