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Some Fixes for a Broken System

Here are ways to shield the imperfect 'net asset value' system from attack.

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.

More redemption fees:

While adding fees might fly in the face of the goals of fund investors and fund regulators, virtually every open-end fund should have a short-term redemption fee of at least 1% for 30 days (at a bare minimum). Investors with time horizons of less than 30 days should invest in closed-end funds and exchange-traded funds, not regular mutual funds. Redemption fees, unlike back-end loads, go into fund capital to offset the costs that shareholder trading creates.

Cascading redemption fees:

The current flat redemption fee does not punish short-term traders enough. The

SEC

is partially to blame on this one, by mandating a 2% redemption-fee limit, which might be fine if foreign markets didn't move more than 2% a day. In practice, what is needed is more flexibility in redemption fees, especially for certain types of funds.

A cascading redemption fee could be as high as 5% for sales within a week of purchase, and then decline by 1% per week down to just 1% for investments up to a year. Such a sky-high, ultra-short-term redemption fee would kill profits from fund-timing strategies.

Next-day trading:

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Funds are long-term investment vehicles. Whether investors can buy at today's closing price or tomorrow's is largely irrelevant. Pooling the buys and sells and holding them until the next day gives the fund manager time to allocate the new cash properly.

With the current system, investors can buy a fund at 3:59 p.m. ET and magically get that day's closing price, even though their money is sitting in the fund's cash and watering down the other investors' exposure because there is no time for the fund manager to actually allocate the new capital before the market closes at 4 p.m. ET.

Let funds have some privacy:

The press, pundits and regulators have lambasted the fund industry for not showing their cards (fund holdings) more often than twice a year. Funds need some degree of privacy with holdings to prevent fund NAV gaming -- if NAV gamers know the exact current holdings, they can create better hedges and know with more accuracy if the fund is mispriced, as well as potentially front-run a fund.

The fund company treachery recently unearthed by New York Attorney General Eliot Spitzer is the most shocking example of shareholder abuse to hit the industry in decades. After announcing a $40 million settlement with hedge fund Canary Capital Partners over allegations that it engaged in illegal trading in mutual fund shares sold by various Wall Street firms and banks -- including

Bank of America's

(BAC) - Get Bank of America Corp Report

Nations Funds,

Bank One

(ONE) - Get OneSmart International Education Group Ltd Sponsored ADR Class A Report

,

Janus Capital Group

(JNS)

and

Strong Capital Management

-- Spitzer has stepped up his probe of the industry.

Fund companies and regulators should use the scandal as a call to action to fix the problem.

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.