How you can help clients deal with the mutual fund scandals.

New York planner John Henry Low is a hard-liner when it comes to the burgeoning mutual fund malfeasance that started surfacing in 2003. Low says that without exception his advice to clients who held funds from the still-growing list of 20-plus fund families that have run afoul of regulators has been simply this: sell.

Low didn't recommend any of the now-infamous funds-all of which are being investigated or have been charged with a host of trading improprieties that shortchanged rank-and-file investors in favor of institutional investors, hedge operators or fund executives themselves. But some of his clients bought Janus and Putnam shares in 401(k) accounts and IRAs, as well as in taxable accounts they manage themselves. Capital gains taxes generated by sale of the funds in taxable accounts were relatively insignificant, the planner maintains.

"Even if there were more significant capital gains, I would have recommended shedding the funds over time," says Low, a principal with Knickerbocker Advisors, which has offices in New York City and Pine Plains, N.Y. "You can't emphasize ethics too much. That's why we have a 'one-strike-and-you're-out' policy. My concern is these funds just aren't good long-term holds. And what about the threat of shareholder runs, which would force the funds to sell stocks and possibly generate investment losses and year-end tax bills?" he asks.

Like many of his peers, Low has taken a reasoned if relatively intolerant approach to the unfolding fund scandals and whether he wants tarnished investments in his clients' portfolios. The good news is that this kind of proactive and rational strategy is exactly the response that will help protect advisors from potential liability, say legal and regulatory experts from around the country.

"The question for planners is, what types of things should they be doing and should they be on the lookout for?" says Mercer Bullard, a former Securities and Exchange Commission official, self-appointed shareholder advocate and consultant to the Financial Planning Association. Bullard, who founded the not-for-profit Fund Democracy four years ago, also authored a series of articles on fund trading abuses for TheStreet.com that were authoritative enough to help launch New York Attorney General Eliot Spitzer's ongoing fund investigations.

"It was very well known that funds were using stale prices that allowed arbitrageurs to capture pieces of client assets," Bullard says. "One could argue that planners should have taken steps to avoid these landmines. There's no solid precedent for this type of claim succeeding, but I think there will be." Bulllard currently serves as a professor of securities law at the University of Mississippi at Oxford.

That's the bad news for advisors. Not every practitioner is in the clear. In fact, even some smaller advisory firms engage in the very type of market timing activities that have been splashed across daily newspapers and TV news, say authorities in the compliance field. "We do find advisors doing market timing with mutual funds. Even some small and mid-sized firms are actively involved," says former SEC regulator Barry Schwartz, a founding partner of consulting firm Adviser Compliance Associates in Washington, D.C. "What we tell them to do is stop. It isn't illegal and there are some funds out there that encourage it, but it can raise red flags," says Schwartz, who, among other things, stages mock SEC audits for advisors and fund firms. Funds have also been cited for late trading, which is illegal and allows larger, favored investors to buy and sell fund shares at the daily 4 p.m. closing price after 4 p.m., in order to take advantage of after-hours news events that will affect the next day's share price.

Of course, market timing isn't new in the advisory industry, and it's not illegal. But with plaintiffs' attorneys closing ranks, advisors' attempts to use frequent short-term trades in a bid to exploit changes in share prices may place a bull's-eye on practitioners' heads. That will be especially true if the market timing activities result in below-average performance and above-average fees.

In short, says Bullard, "Planners should think about these nonperformance issues going forward. The real risk is you put clients in something like the Heartland Funds, where pricing and the fund's relatively long, problematic history suggest that there are significant problems."

In other words, advisors who use funds with knowable track records of abuse are ignoring explicit warnings, Bullard says. One Heartland fund, for example, lost 70% in one day as a result of mispricing. Three years later, the same board that allowed the problems is still essentially intact. Advisors' may have a hard time justifying that their due diligence and risk-reward analysis led them to these funds. "This is not an industry where you can argue that there aren't funds with strong compliance options."

Bayard "Bud" Bigelow III of The Cambridge Alliance LLC in Vermont, one of the leaders in advisors' errors and omissions insurance and a guru in helping advisors avoid and defend against investor claims, agrees that fund ignorance won't be bliss for practitioners. While he believes that fund managers and directors will be the first line of defendants in investor lawsuits, "burying your head is not a good option right now for advisors," Bigelow says. "That's essentially the major liability I see for advisors, when a public announcement is made about a fund family and an advisor doesn't act one way or another even though it affects clients. Of course, you could act too precipitously or not quickly enough. There are all kinds of ways to walk into trouble."

But there is also some room for advisors who are determined to engage in riskier investment activities, as long as the activities are above-board with clients. That even applies to market timing. "If you're determined to do market timing, my advice is use the funds that encourage it," says Schwartz. "It's also critical to make sure clients fully understand the market-timing strategies you follow and all the risks involved."

Active market timing may prove to be more costly to advisors and their clients as fallout from the fund scandals escalates. But other actions, or lack thereof, also can have dire consequences for advisors who have something to hide or lack the fundamental competence or will to help clients do the right thing.

In fact, having to backtrack on investment choices gives more than one advisor waking nightmares. "If I were a broker and sold Putnam and Janus and Strong and so on, it would just be terrible to apologize to clients and then watch them sustain tax losses to get out of the funds," says John LeBlanc, a principal of Back Bay Financial Group in Boston.

On the other hand, for advisors who put client interests first "this is a good thing," LeBlanc adds. "Advisors on the same side with their clients look like stars. Clients realize that we're doing the right thing for them."

That doesn't mean that LeBlanc, Low or other advisors profess to have a crystal ball when it comes to knowing which fund complex may fall next. Most experts agree that the end of the scandals is not yet in sight. To the contrary, better advisors are telling investors point blank that they can't know the future, they can only do their utmost due diligence to protect against known risks.

"Currently we do not hold client funds in any of the families that have been implicated except minimal amounts in Janus Funds, which are being liquidated as appropriate," Boone Financial Advisors of San Francisco wrote to clients in November. "Should any of the other fund companies we work with be implicated in these types of activities, we will carefully evaluate the circumstances and nature of the problems uncovered. Where there is evidence that the activities arise from a business culture that fails to adequately emphasize the fiduciary duty of the company, we will consider liquidating such holdings and finding more suitable investments."

What could be more clear than that? A little proactivity on advisor's parts can go even further. "We were able to communicate to clients that funds that we're using assured us that they weren't involved in any of these trading activities," says David Strege, a principal with Syverson, Strege, Sandager & Co. in West Des Moines, Iowa. "This gives us a chance to communicate to clients what is happening and what impact, if any, it has on them," Strege says.

It also gives advisors a chance to use the way they select funds, and the way they are selected by funds, as a badge of honor. For instance, LeBlanc says that 27% of the assets of his firm's clients are invested with Los Angeles-based DFA (Dimensional Fund Advisors) which, despite catering almost exclusively to institutional investors, forbids its clients from market timing its funds.

The historic events caused by fund trading abuses have another silver lining, beyond focusing investors' attention on seeking assistance. That silver lining is the klieg light that's being aimed at fund fees. "Going forward, there is absolutely no reason to think about investing in a fund that has [substantially] above-average fees," says Bullard.

Pricing transparency should improve greatly if the pending fund reform legislation introduced by Rep. Richard Baker (R-La.) passes. The bill requires the disclosure of not only portfolio transaction costs, but also of brokerage commissions. New York's Spitzer fired an equally chilly warning shot over the bow of the industry in December, when the settlement he negotiated with Alliance Capital to settle the company's trading transgressions-namely allowing a number of large clients to engage in market timing-required the firm to roll back its decidedly high fees by $350 million over the next five years.

Although the SEC negotiated a separate $250 million settlement with Alliance Capital, agency officials pointedly declined to set fees at the complex, saying they believed that all restitution should go to victims, not future investors. And while most observers now acknowledge what fund critics have charged for years-that mutual fund fees are too high-more than a few question whether it's within a state attorney general's purview to tell funds what to charge shareholder.

With the SEC sidestepping the issue, it's imperative that state regulators like Spitzer require funds to reduce fees, says Edward Seidel, president of Florida-based The Benchmark Companies. Seidel investigates fund fees and operations for pension fund clients, and says that in most cases he analyzes pensions are indeed being overcharged. "If institutional clients are routinely charged too much, how can small investors demand fair pricing on their own?" Seidel asks.

Boston advisor LeBlanc says his clients are taking a hard look at what they pay for funds as a result of the scandals. The day may be coming soon when it will be up to advisors, not just funds, to ensure fees are fair.