Updated: May 3, 2013 12:14PM
Originally published: November 6, 2003
The mutual fund industry controls nearly $7 trillion in assets, and today the rightful owners of a lot of that money -- individual investors -- are justifiably enraged by the market-timing and late- trading scandal. Well known names like Putnam, Strong and Prudential, as well as funds managed by Bank of America and Bank One, have admitted to some of these activities. Market timing is not illegal; late trading is. But both deprive investors of money they’re entitled to.
It’s not just the magnitude of the losses -- which cost the average investor an estimated 1.1 percent of assets in 2001. It’s the complete contempt for the average fund investor that these activities represent that makes the situation so outrageous. It’s bad enough that investors suffered through a bear market, but this behavior adds insult to injury.
What should investors in these funds do? Let’s examine the facts before considering what action to take. While the funds named above are making headlines, it’s been reliably predicted that many more fund families may have engaged in these practices. So if you pull your money out in haste, you could be jumping into the same mess elsewhere.
It will take a few months for this scandal to fully evolve, but you may not have time to wait it out. But you must consider some potential consequences of selling out:
* Tax consequences. If you own your shares in your own name instead of inside a retirement account, selling will result in a taxable gain -- or tax-deductible loss. That depends on your original cost basis, which may be difficult to determine if you’ve reinvested dividends and gains over the years. But you’ll face the tax consequences when you file your tax return next April, and may even be required to ante up estimated taxes in January if your sale results in big gains.
* Cost of withdrawal. Many funds have commissions, sales charges or “back-end loads” that can cut into your cash-out check. Make sure you know about these costs and the impact they’ll have on the amount you can reinvest elsewhere.
* Retirement accounts. As angry as you may be with the fund company, don’t just sell and demand a check. If the money is in a retirement account such as an IRA or Keogh, you’ll be liable for taxes on the gains, as well as a 10 percent penalty for withdrawals before age 591/2. Instead, open an account at a different fund company, and have the money transferred -- rolled over -- directly into your new account.
That brings us back to the original question: Should you take your money out of a fund company that has been accused of participating in this scandal?
Given the considerations above, my answer is an unqualified yes. And I’ll add to that, an unqualified now.
Here’s why: Most of the affected mutual fund companies also manage huge accounts for pension funds, endowments of universities, and other big institutions. And the trustees of these institutions don’t want to post a year-end investment statement that lists companies like Strong, Putnam, or Prudential as money managers. So they’re voting to pull out big chunks -- millions of dollars -- of managed money from these fund companies.
The institutional withdrawals will affect mutual fund shareholders in several ways:
The money mangers typically buy the same mid-cap or small-cap or growth stocks for their managed accounts as for their funds. They’ll have to start selling those stocks to pay off the huge institutional withdrawals. That will impact stocks in the fund -- and fund share prices.
Then, when individuals close out mutual fund accounts, the managers will have to sell stocks inside the funds -- creating transaction costs, as well as capital gains, or losses, for those who remain shareholders at year end.
And finally, these money managers are likely to be distracted by the process of raising cash to pay off departing shareholders -- leaving less time and energy to focus on making money for those remaining.
I don’t want to cry “fire” in a crowded theater, or start a run on these funds -- but you have to face reality.
As money is withdrawn from these funds, there will be higher costs and tax consequences for remaining shareholders. You may not want to be one of them. But if no one stands up and points this out now, by the time you notice those effects it will be too late.
And that’s the Savage Truth.
Terry Savage is a registered investment adviser and is on the board of the Chicago Mercantile Exchange and McDonald’s Corp. She appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast, and can be reached at her Web site, www.terrysavage.com.