Commentary: Funds: Leaving Little Guys Out In The Cold

The SEC's cleanup of mutual funds could shortchange small investors

Newly energized by the mutual-fund scandal, the Securities & Exchange Commission is readying new rules to stop abuses. But some of its proposals could penalize the little guys, instead of the big traders and fund promoters who connived to profit so handsomely.

Consumer advocates and 401(k) retirement-plan sponsors fear that small investors will be denied the most up-to-date prices on funds, get hit with new fees -- and still won't be told what it costs them to own mutual funds. "The SEC is punishing the innocent to prevent abuses by a few insiders," fumes David L. Wray, president of the Profit Sharing/401(k) Council of America. The SEC needs to rethink its approach on three fronts:

LATE TRADING. To stop after-hours stealth trades by favored investors, the SEC wants funds themselves to have all orders in hand before they set prices at 4 p.m. Eastern time. That way, no one can trade on late news that's likely to move prices the next day.

That's no problem for investors with a direct line to funds. They could still place orders at, say, 3:50 p.m. But 401(k) administrators say the cutoff would force workers to place their orders as early as 7 a.m. on the West Coast to make sure they comply with the new rules. So they would have to buy or sell based on the first half-hour of New York trading -- or miss out on that day's price.

The SEC concluded rightly that most 401(k) participants are long-term investors who shouldn't be bothered by a one-day delay. But a hard 4 p.m. close still punishes the wrong people. The SEC should view it as a temporary fix and push industry to solve the problem with better technology. For example, Hewitt Associates, which processes trades for 5.5 million 401(k) participants, says computer systems that time-stamp orders could be encrypted to make them tamper-proof. Such procedures could be backed up by an outside audit.

MARKET TIMING. To discourage fast in-and-out trading, the SEC plans to impose redemption fees on fund investments held less than five days. The goal is to keep rapid traders from exploiting the stale prices of foreign or thinly traded stocks in mutual funds.

Mandatory fees suit the fund industry just fine. A levy of 2% or more will lock money into funds. Even one SEC official derides funds that already charge such fees as "2% roach motels." They could hurt small investors who need money for medical or other emergencies. And 401(k) plan participants could get socked if they sell within five days of an automatic payroll contribution.

The SEC already knows the right solution: Force funds to always use fair-value pricing, a fancy term for putting a current market value on a stock whose price has become stale. On Dec. 3, the SEC warned funds that they must update stale prices -- but stopped short of requiring daily fair-value pricing. And the SEC on Dec. 11 was expected to remind funds of their responsibility to value assets properly in a civil fraud case against Heartland Advisors, several of its top officials, and directors of two Heartland funds.

FEE DISCLOSURE. If the SEC really wanted to help small investors, it would force funds to disclose fees clearly. After all, the estimated $5 billion investors lose annually to market-timing is dwarfed by the $75 billion they pay in fees. And with funds' poor disclosure -- fees are stated in annual reports only as a percentage of assets -- "most investors have no idea what they're paying," says former SEC commissioner Steven M.H. Wallman, now CEO of brokerage FOLIOfn Inc.

The SEC wants funds to show in their semi-annual reports what an investor would have paid in dollars on a hypothetical $10,000 investment. But that's just a percentage in a different guise. What each investor needs to know is what he or she actually paid, in dollars, just as with stock purchases through a broker -- shown prominently on personal quarterly statements, not buried in documents that few ever read.

Give the SEC its due: Many of its reform ideas will promote a cleaner fund industry, with stronger compliance and more independent boards. But the agency can't lose sight of its mission. It must put the burden of cleaning up the scandal on the real perpetrators -- not on small investors.

By Amy Borrus

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