WHEN TIMES GET TOUGH, PEOPLE AND COMPANIES GET TOUGH, OR IN SOME CASES, BECOME UNETHICAL.

That’s where many mutual funds found themselves during the past three and a half years during a not totally unexpected bear market and a technology stock implosion overseen by inexperienced, and in many cases, unethical executives.

A handful of mutual funds have recently opened themselves up to close scrutiny by both a State Attorney General and the Securities and Exchange Commission. News of various allegations, such as market timing, broke early in September when Eliot Spitzer, the Attorney General of New York announced a $40 million dollar settlement with a hedge fund, Canary Capital Partners, L.L.C., that allegedly engaged in illegal trading schemes with several large fund companies. The actions potentially cost investors billions of dollars, according to Mr. Spitzer.

Canary is charged with engaging in special trading opportunities with top fund companies – and here, quoted from Investment News in September are the companies: Bank of America Corporation in Charlotte, NC; Bank One Corporation in Chicago, IL; Janus Capital Group, Inc. in Denver, CO; and Strong Capital Management in Menomonee Falls, WI – in exchange for promising to make substantial investments in various mutual funds managed by these institutions. The New York Attorney General’s office has also subpoenaed a number of large hedge funds and mutual funds as part of its investigation into improper trading practices. Among the subpoenaed fund groups were the Vanguard Group, Inc. of Malvern, PA and INVESCO Fund Groups Inc., a Denver based unit of AMVESCAP, L.L.C. in London, according to published reports. None of these three have been charged.

This news has set off a flurry of articles in the media questioning whether mutual fund companies were appropriately placing the interest of their shareholders above all else.

While at first, the Securities and Exchange Commission had very little comment on the actions of the New York Attorney General, they have now applauded his investigation and are beginning to join forces in the state’s investigation.

When large amounts of money are moved in and out of mutual funds, it causes increased trading costs, which in the long run, translates into bad news for the long-term investor.

"So, How Does This All Affect Me?"

While we haven’t received a lot of phone calls or inquiries into the effect these investigations have had on our fund groups, many have wondered what the positions are of the major fund companies we represent. Later on in this column you’ll see some explanations of the two problems that have occurred.

How Does This Affect American Funds, And What Is Their Policy On These Practices?

American Funds does not allow late trades. The trades must be received by either the transfer agent, American Funds, or third parties that have contractual arrangements with American Funds Service Company, such as broker/dealers and retirement plan record keepers, before 4:00 pm Eastern Standard Time, for those orders to receive that day’s price. Late trading is considered to be orders placed after the 4:00 pm EST deadline. Late trading allows an investor to receive today’s price for orders submitted after the cut-off time. Late traders can take advantage of news events that take place after 4:00 pm EST to profit at the expense of other shareholders.

What About The American Funds Policy On Market Timing?

These funds have never been designed to serve as vehicles for frequent trading. There are a number of people at American Funds who monitor shareholder accounts to determine whether they are engaging in excessive trading. It’s American Funds policy that if they find someone who is doing this, they will first warn the shareholder and then by freezing trades in their account they essentially require that the shareholder leave the fund. Other procedures control the review of significant price movements in the US markets and adjust non-US securities’ prices to capture the potential impact that these movements may have on non-US markets. This procedure seeks to remove the harmful effect of any market timing that does occur in these funds.

According to officials at American Funds, they would never agree to waive any of their policies regarding trading in mutual fund shares for particular shareholders in exchange for receiving some sort of benefit, which is what is alleged that the four fund groups did.

Any time the SEC becomes aware of issues like these they conduct broad based examinations of the mutual fund industry. Because of the size of the American Funds, we are certain that they will be included. Accordingly, the SEC has requested information from 80 different fund groups, including American Funds, regarding practices in this area. The American Funds officials intend to fully cooperate.

"YOU CAN’T SERVE TWO MASTERS."

So what causes mutual fund management companies to submit to the whims and greed that has so permeated corporate culture in the last decade? We forget that managers of publicly traded assets serve two masters: their own stockholders and their mutual fund customers.

The trouble is, serving both, causes inherent conflicts. Fund shareholders, or clients, benefit from lower fees which result from deeper research and fewer turnovers of stocks in the portfolio, while fund company stockholders benefit from higher fees and allowing funds to grow beyond management’s ability to run a portfolio. A Morningstar executive, Kanul Kapoor recently quoted in Investment News stated: “Fund companies that tend to be focused on the long-term can take more of a shareholder-friendly approach and do well by both their stockholders and their fund holders, whereas those that are focused on meeting the next number that Wall Street has out there, are invariably going to do whatever it takes to get where they want to be.”

A spokesperson from American Funds has reminded us that their present organization is a privately held company and is not subject to outside shareholder pressure.

OUR OPINION

It has been our observation that during times of roaring bull markets, mutual funds always attract plenty of assets, especially those no-load funds which operate in aggressive arenas. Since performance drives most funds, attracting assets during those good times is not a difficult proposition. So the typical Bull Market investor says: “If there’s no sales charge, why should I pay one when I can get as great a return for free?” But then when things get tough and the markets turn down, or flatten, we find the old adage is still true - “Mutual funds are not bought; they are distributed by real people”. People begin to look to advisors for help.

It is quite difficult to buy or hold when markets are bearish without an advisor’s encouragement.

During the times when nobody wants to buy, intelligent investors acquire shares at sometimes bargain prices, holding for the long-run. By having long-term-minded managers while reinvesting dividends at lower prices, the “buy and hold” investors own more shares than they started with as the market comes back.

"Let’s roll the dice. I want 20% again!"

During treacherous markets, many investors have turned to Hedge Funds attempting to get the high double digit returns they enjoyed in the 90’s.

Mr. Jack Bogle, with whom we agree in only a few cases, accurately points out in a recent issue of SunGard World that 700 Hedge Funds went out of business last year. That is almost one-sixth of them. Also for a Hedge Fund to deliver a 7% return after costs and taxes – and they are very tax efficient – they’ll need to average about 15%, and that’s not an extreme example.

If the stock market returns single-digit numbers over the next several years, it’s easy to imagine the Hedge Fund managers taking quite a bit of risk to return to their shareholder 15% - 20% after extremely high expenses.

With that knowledge, you can understand how Hedge Fund people at Canary Capital Partners would look for any advantage available.

We believe that all the mutual funds, investment company officials and unethical broker/dealers involved should be fined and, if illegal acts have occurred, be prosecuted to the fullest.

That’s Our Take. Yours is Welcome.