Mutual Funds Need Tighter Rules

It doesn't get much better than this. Mutual-fund investors, who plunked down $128.2 billion last year for equity portfolios, racked up an average of 20% total return--doubling the Standard & Poor's 500-stock index and far surpassing what they could earn with certificates of deposit. So happy are customers that they now entrust $2 trillion of their money to funds. With the Dow heading toward 4000 and interest rates remaining low, that figure is sure to soar.

But there have been some disquieting revelations about how some mutual-fund managers behave. To the surprise of many new investors, it turns out that fund managers are permitted to trade for their own accounts while managing publicly owned portfolios. In at least one case, it appears that a fund manager got into a private placement, thanks to the favors of a stock promoter. The same promoter turned out to be offering stock to the manager's fund.

That mutual-fund manager was accused of violating the fund's rules on personal trading. Another resigned to move to another fund after an internal investigation cleared him. It is now clear that what is permitted varies from one fund group to another. Worse, very little information is made available to the investor.

The issue is not a legal one. Such trading practices as front-running, whereby managers buy stock for their own account and then buy it for the fund, pushing up the price of their own equities, are illegal. But the gray areas abound and beg for both transparency and close monitoring.

One way for the mutual-fund industry to retain its squeaky-clean image is to forbid its managers from trading for themselves. Tie their compensation to the performance of their portfolios. If they want to participate personally in the market, let them buy the same funds their customers do--on the same terms.

A number of mutual-fund groups actively encourage their managers to trade for themselves. They want them to have a good "feel" for the markets. For these funds, full disclosure and close monitoring by a third party of all personal trades and investments is in order. Indeed, personal trades by managers that overlap with the fund's investments should be disclosed to the public owners of the mutual fund in a timely fashion.

The mutual-fund industry has been a glorious financial success story for millions. It should strive to keep their trust by taking immediate steps to retain its Mr. Clean image.

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