How to Police Your Fund

Time to play detective: Here are the clues to whether your mutual fund is ripping you off.
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Is your mutual fund ripping you off?

Allegations of fund dirty dealing are spreading. Each day fund investors are bombarded with news of new schemes to skim profits from longer-term, smaller investors. What's a person to do?

The parade of articles and TV segments may lead investors to the wrong decision: that the fund industry is a big con game run by crooks and insiders and that you should bail out immediately. But there are more proactive steps available for investors who want to avoid questionable funds.

As any TV detective drama fan knows, for a crime to take place, there has to be a motive. What are the motives and clues in mutual fund dealings? Call it mutual fund profiling. In a court of law you need to prove beyond a reasonable doubt that a crime was committed, but as an investor you may simply want to avoid a fund that smells fishy. You are allowed to discriminate when investing.

The increased regulatory and public scrutiny will surely cool down bad behavior at funds in the same way a crime ring has to lie low after a police crackdown, but here are some good clues to whether you might want to question your fund:

Rule 1: Avoid Load Funds

The motive for all fund companies is simple: make more money. However, for most no-load fund families, making more money is best achieved by having the best-performing funds. Past performance (unfortunately) sells itself, and a fund that beats competitors brings in far more money than any short con will generate.

Because of this fact it is not likely that a typical no-load fund family would do anything intentionally that would significantly compromise fund returns. Most no-load funds simply don't have the motive to ruin fund performance.

Load funds are not just bought by past performance, they are sold by brokers. As covered in my article about

Morgan Stanley, load funds may be sold by a broker because the broker is competing in some Glengarry Glen Ross-type prize competition, not because it's the best fund for the client.

So far, most of the funds currently named in the scandal are load funds.

Rule 2: Avoid Fund Families With Major Business Interests Besides the Funds Themselves

This one is tough to follow because almost all fund advisers have some sort of business going on besides the mutual funds they manage, be it separately managed accounts, hedge funds or brokerage services. However, if mutual funds are a company's main source of revenue, they are less likely to do anything to compromise their core business.

If the fund company is really a large bank (such as

Bank of America

(BAC) - Get Report

, which is in hot water for its fund dealings), it will have other interests besides mutual funds. It may have ultrahigh net worth clients, or hedge funds that pay higher fees than mutual funds. It may use the funds as a tool to grow other more profitable lines of business.

How do you know if your fund is facing a possible conflict of interest? Call the fund adviser and ask how much money the company has under management, and how much of that is in funds vs. other products. Find out if the company has brokerage or investment banking operations, or manages hedge funds. Again, most funds with side businesses are legit, but why invest in their nonpriority, low-margin product when there are plenty of great investment advisers whose fund business is their main business?

Rule 3: Consider Index Funds

Index funds offer an unusual benefit in the war against fund-trading crimes and misdemeanors. Fund companies can't let index funds get ripped off by fund net asset value-timers because it would be painfully obvious if a fund missed its benchmark index by 1% or 2% a year. It would be difficult to match a benchmark index if illicit fund timing were stealing returns from the fund.

The reason the industry scam could go on unnoticed for so many years is that investors have little way of knowing it is actually going on at an actively managed fund because there is no pure benchmark.

With actively managed funds, we will never know precisely how well a fund would have done had there been no questionable fund-timing behavior, whereas with an index fund we would have a good idea -- the index return minus normal fund friction and fees. Imagine trying to pass off a

Dow

index fund that was up 5% when the Dow was up 10%?

Rule 4: Avoid Large Funds

No self-respecting greedy fund or brokerage outfit is going to break the rules for an investor with $100,000 or even a million dollars, but some will look the other way for somebody with $50 million or $100 million. But there's a hitch: Funds can't let an investor with $100 million go in and out of a fund every few days if that fund has only $150 million in total assets. Transactions of that size would wreak havoc in a small fund. Recent scandals involved giant funds allowing big fish investors to steal a little from a mammoth fund.

Keep in mind the vast majority of funds don't want investors timing their funds -- they have timing police to catch questionable accounts. This is not because of their high moral standards so much as they are looking out for their funds' best interest: performance. It's far easier for a fund company to notice illicit flows in a small fund.

Because they need to go unnoticed, fund timers -- the run-of-the-mill active traders who swamp fund companies daily as well as the sophisticated stale-NAV skimmers -- target larger funds. Who wants to break into a car parked in front of a police station?

Rule 5: Avoid Hot Money

A fund with a stable asset base has many benefits, and none more relevant than this: A stable asset base usually means there is no massive inflow and outflow of investor capital. Avoid funds that swing from $500 million to $1.2 billion and back to $700 million, all in one year. Such flows means a fund has been taken over by timers, short-term players and performance chasers -- to the detriment of a longer-term investor.

Hot money can be kept at bay by avoiding funds that: 1) have no short-term trading restrictions, 2) are very common on fund brokerage supermarkets, 3) have recent hot track records, 4) are in everyone's 401(k) and 5) that allow easy transferring in and out of funds.

Sadly, redemption fees, which are a good thing, are not a be-all and end-all stop to hot money because fund companies occasionally waive redemption fees for "preferred" clients.

High turnover can be a clue that there is hot money in a fund because the fund manger has to trade frantically to meet the subscription and redemption demands of criminal and legal timers.

Rule 6: Avoid Management and Control Changes

Sometimes key executives leave fund companies they founded. Or they sell their fund company to a giant foreign bank. Or there is infighting. Either way, changes in management can lead to a lack of oversight and authority or worse, a lack of care and conviction.

Janus

(JNS)

comes to mind. People start bickering about who is making the most money, and nobody notices an aggressive sales agent who cuts a deal with the devil to make a few bucks.

Large banks don't think of a fund family they bought as anything but a way to make money. If they can dream up synergies that can make them more money, so be it. To them, a fund is not a place that shareholders put their trust, or a place with their good name on the shingle, but a simple formula of assets times management fees.

Rule 7: Avoid Load Conversions

In recent years, many no-load funds have converted to load status.

Strong

, recently named in the fund scandal, is one example. It's one thing to launch a load-fund family from scratch. But to actually build a multibillion-dollar fund complex pitching the benefits of no-load investing, and then convert to load classes raises questions of motive.

Was the no-load fund philosophy just a marketing tool? It's like saying, "All that junk we said about 'no-load good, load-fund bad' over the last 20 years was bunk. Now it's 'no-load good, load-fund better,' at least if it means more assets under management."

It shouldn't surprise anyone when a load converter gets implicated in the fund-timing scandal -- clearly asset growth is a be-all and end-all and shareholders' best interests are not a concern.

Jonas Max Ferris is co-founder of

MAXfunds.com, a fund research and analysis company, and partner in an investment advisor offering managed accounts in mutual funds. He welcomes column critiques, comments or baseless accusations at

jferris@maxfunds.com.