Brewster, who relies mainly on index funds, says the scandals provide additional fodder for arguments in favor of passive investment management. "Scandals like these are reason enough to avoid actively managed mutual funds and invest solely in index funds," he says. "Passive index investing allows you to avoid the risk of rogue managers and general improprieties. Index funds are far more transparent, and their goals are clearly defined."
Financial advisors who favor actively managed funds still see room for improvement in key issues such as disclosure. "Prospectuses are still unfriendly and should be simplified," says Jetton. "Reading one is something like trying to climb a mountain without trail markers."
The frustrating thing for many advisors is that, even though mutual funds are transparent when compared with hedge funds and other types of investments, costs generated by after-hours trading and soft dollar deals can easily elude detection. Unlike sales charges and investment management fees, which require clear disclosure in prospectuses and other fund documents, such stealth practices can be quietly buried, yet potentially costly. And the worst may not be over if the SEC ignites new controversy by uncovering damaging information about how much those practices cost investors.
Despite such concerns and the recent spate of scandalous headlines, many financial advisors continue to believe that the policies in place at most fund companies protect the interests of shareholders. Without that belief, they would need to re-examine the very core of their investment philosophies, and the basis of their businesses. The question now is whether the industry that has provided the products they need to attain success will take the actions necessary to retain their trust-and the trust of their clients.
Common Practices Or Isolated Cases?
Despite the widely publicized fund scandals involving late trading and market timing, many financial advisors feel that such practices are limited to a minority of funds and represent isolated incidents. Recent research from Stanford University, however, points to a different conclusion.
Eric Zitzewitz, an assistant professor of strategic management at Stanford Graduate School of Business, examined a sample of data covering 10% to 15% of the mutual fund industry soon after the New York Attorney General office's announcement of its investigation into whether specific mutual funds had colluded with hedge funds to facilitate the illegal practice of late trading. Based on data from TrimTabs Investment Research, which tracks fund daily assets, returns and distributions, he estimates that the effects of late trading cost individual shareholders five basis points for international funds and 0.6 of a basis point for U.S. equity funds. He found evidence in the sample that late trading had occurred in the international funds of 15 out of 50 fund families, and in 12 of 96 domestic fund families. His agreement with TrimTabs prevents him from naming the families involved.
In earlier research, Zitzewitz studied market timing, a practice that is not illegal but one that can be costly to shareholders. "While the amount of long-term shareholder wealth lost due to late trading is large in absolute dollar terms, it is small relative to that lost to market timing," he concludes. "It is also probably smaller than the impact of excess trading due to incentives created by soft dollars, and smaller than the cost to investors of choosing high-expense-ratio index funds."