Posted on: Friday, November 7, 2003

State ERS board confronts Putnam allegations

By Deborah Adamson
Advertiser Staff Writer

It's one thing when you read about the mutual fund industry scandal in the papers. It's quite another when you see the company being investigated is yours.

Suddenly, the widening scandal on Wall Street has hit Main Street, with real implications for your investments and retirement money.

Several mutual fund companies are under investigation for market-timing or conducting illegal late-trades on funds. Such actions can hurt returns of long-term fund shareholders and favor some investors over others.

The list of companies targeted is long and getting longer: Putnam Investments, Strong Capital Management, Janus Capital Group, Bank of America's Nations Funds, Bank One's One Group, Federated Investors, Fred Alger Management, Prudential Securities and Alliance Capital Management.

Today, the state Employees' Retirement System board will discuss whether to pull the plug on Putnam.

Putnam, which is being investigated for alleged fraud, handles $440 million of $8 billion in pension money for 93,000 public employees.

The state Deferred Compensation Plan, which has $43 million with Putnam, decided to stick with the firm pending further developments.

But more widespread is the impact of the fund scandal on your 401K plans, Individual Retirement Accounts, and other investments. Many of these companies targeted by the probe offer funds that could be part of your nest egg.

Tax ramifications

So what should you do?

First, don't give in to your instinct to sell now and think about it later, said Tom Roseen, an analyst at Lipper Analytical, a Denver firm that tracks the mutual fund industry.

With the stock market on a healthy rebound — the S&P 500 is up 20 percent thus far this year — your investments are probably enjoying some gains. If you've held the fund through the last bull market, you could be hit with substantial capital gains taxes if you sell now.

"Examine the tax ramifications," said Harry Kasanow, a certified financial planner and president of Honolulu-based Kasanow & Associates: Wealth Management.

Besides, if you switch companies, "how do you know that the next fund you'll jump into won't be involved in this? (The fund probe) is still unwinding," Roseen said.

If you're worried you'll lose the money in your fund, rest assured that the funds are held in a trust and thus protected from the ills befalling a fund company, said Charles Foster, a certified financial planner at Blankinship Foster in Del Mar, Calif. It's not like buying stock in a company, where shares could become worthless if the business fails.

A mutual fund is a pool of money collected from many investors. The money is invested by a fund manager employed by a mutual fund company, which charges fees and other expenses for the service. The mutual fund is divided into "shares"; the more money you put into it, the more shares you'll get. Each share represents a slice of the total investment — whether it's in U.S. stocks, foreign corporate bonds, or others.

Even if a mutual fund company fails, you won't automatically lose your money because it's invested in stocks, bonds or other securities within a fund and not the fund company itself. Thus, buying shares in a Janus fund is not the same as buying the stock of Janus, the company.

If the fund company fails, another fund manager from a different investment firm could take over.

Distrust plagues industry

Another reason investors should chill out: People haven't actually lost large sums of money. Rather, it's the public's growing distrust that's plaguing the fund industry.

"What we are talking about is the lack of trust rather than the loss of dollars to investors," Foster said.

Investors probably lost 0.1 percent of their return if improper trading was done on a small scale and 1 percent if it's widespread, he said.

"It's not that bad and its fixable," the financial planner said. "It shouldn't cause people to run over the cliff and kill themselves."

Moreover, several firms in the probe have pledged restitution for losses related to improper trading.

Still, investors should care about the scandal because market timing and late-trading does increase trading costs, which are borne by all shareholders in the fund. If the trades are profitable, it could boost capital gains taxes for all even if only a few take the spoils.

Moreover, if state pension funds and other investors continue to pull money out of these fund companies, they could cause share prices to fall, fees to rise or even cripple the firm.

Reevaluate portfolio

When money is pulled out of a fund, the manager may have to sell securities if he or she doesn't have enough cash to pay investors back. Such selling could make the fund's share price fall, affecting investors who stay with the fund, Foster said.

The more assets, or money, a fund company handles, the greater its ability to spread out its costs to a larger group of investors. When the assets shrink, the fund company might end up charging the remaining investors with higher fees.

If you want to be proactive, here are some things you can do:

• Take this opportunity to reevaluate your portfolio, Roseen said. Since it's close to the end of the year anyway, review your asset allocation to make sure your money is spread out among investments that can meet your financial goals. If the fund that's being handled by an embattled fund company is one that doesn't fit your needs anymore, then consider selling it.

• Look at the fund's performance, not just the fund firm, Kasanow said. For example, Janus might be under investigation, but its Janus Global Technology Fund is up 45 percent year-to-date. The fund is recovering after losing 33.7 percent, 40 percent and 41 percent in 2000, 2001 and 2002, respectively. Since the fund is rebounding, investors might consider holding on.

• Do you trust the fund company? If it's a few rogue managers misbehaving and the company disciplines them promptly, consider staying. But if it's a company culture that promotes such unethical or illegal activity, bail out, Foster said. How do you find out? Look for a pattern of violations.

• Don't want to deal with the possibility of misbehaving managers? Consider exchange-traded funds, or ETFs. This is an investment product that acts like a stock and a mutual fund. An ETF represents a basket of securities that mimics an index such as the S&P 500. Its multiple investments make it like a mutual fund. But like a stock, an ETF share is bought and sold in the stock market through your broker. You don't have to deal with a fund manager.

While ETFs generally have low annual expenses, your costs could add up if you trade them frequently.

Reach Deborah Adamson at dadamson@honoluluadvertiser.com or 525-8088.