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 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."

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