by Cynthia Harrington

Over the last few years, investors have been learning a new vocabulary. They picked up “off-balance sheet financing” from Enron, and “capitalizing expenses” from WorldCom.

Now “market timing” and “late trading” have become part of the lexicon, thanks to the mutual fund industry. And investors are bringing their new language to advisors and asking them to translate it in terms of what they need to do.

“The best advisors have contacted their clients to explain what’s going on,” said Chris Frederiksen, CPA, of Client Wealthcare, in Mill Valley, Calif. In addition to advising his clients, Frederiksen talks to CPAs across the country who attend his seminars on expanding into financial services.

“This is not a new phenomenon, but we’re surprised at the scope of it,” says Frederiksen. “But most advisors are advocating not to panic. However, if it’s in the clients’ best interest to move, then advisors are finding alternatives.”

Several things stand in the way of moving assets, though.

Investors could be hit with fees to leave and additional charges to reinvest. Clients with their assets in 529 plans or 401(k)s could be stuck because shifting is restricted or alternative choices are limited. “Not all investors can just leave,” said Dan McNeela, a fund analyst at Morningstar Inc., in Chicago. “Some investors could be hit with a big tax liability that would be a certain loss.”

McNeela thinks that shareholders with limited choices now may have greater flexibility in the future. “I could imagine that some defined-contribution plan sponsors that are now with a single fund family will work to broaden the offerings,” said McNeela. “And I can imagine that states with restricted 529 plans will call for reviews. With the 529 plans, I would wait to see what the states are going to do about expanding the choices of investments.”

Generally, the advice of the experts is not to panic — to sit tight, but don’t put any more money into the troubled funds. “We don’t think advisors should send any new money to Putnam at this time,” said McNeela. “These ethical problems are very serious. The fund company showed blatant disregard for shareholders’ interest.”

Broker/dealer H.D. Vest recently formulated advice for its 6,000-plus affiliates. “We’re disturbed because any mutual fund doing this harms the advisor with a long-term perspective,” said Roger Ochs, JD, MBA, CFP, CLU, and president of Irving, Texas-based H.D. Vest Financial Services. “We are paying particularly careful attention to this situation, because Putnam is a long-standing partner of ours.”

Ochs reported that H.D. Vest has put the four problem funds at Putnam on hold, and that Putnam is on their watch list. H.D. Vest is in daily discussions with Putnam management, while Vest’s portfolio managers are on the scene in Boston to carefully evaluate the funds’ performance. On top of the intense scrutiny of the fund company, Vest works with affiliates to get accurate information to their investment clients.

For instance, only about a quarter of the assets leaving Putnam belong to individual investors. “We’re helping affiliates help their clients understand that the institutional redemptions from Putnam won’t directly affect the mutual funds that individuals hold,” said Ochs.

“Institutions often get distributions in kind and from different pools of assets, so this does not affect the decisions of the portfolio managers of the funds our clients own,” he added.

H.D. Vest is watching for the new management team to restore confidence. Putnam cleaned house by firing the portfolio managers who were involved in the marketing timing trades and ousting chief executive Lawrence Lasser.

“The big-picture question is whether the overall fund
company has made adequate changes at the top to limit any systemic damage,” said Ochs. “We’ve got a lot of confidence in [Putnam’s new chief executive] Ed Haldeman. But until we get comfortable with the new
management team and the new portfolio managers, we’re watching very closely.”

Advisors are monitoring the situation for changes. Increased confidence in management and no further announcements of wrongdoing may mean that they’ll again recommend these funds to clients. If performance drops as a result of the misdeeds or if the new management continues the illegal activities, advisors will pull assets.

“I’d advise anyone to get out if we had a situation where there was a real run on the bank,” said Frederiksen. “If a fund family lost half its assets, for instance, then the remaining investors would have to bear unreasonable costs.”

The mutual fund trade group, the Investment Company Institute, rushed to restore public confidence. Chairman Paul G. Haaga Jr. testified before the House Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises in early November. Haaga brought proposed solutions, as well as the message that the industry would deal with the few bad apples.

The ICI forwarded its recommendations to the Securities and Exchange Commission to further inhibit late trading and market timing activities. Chris Wloszczyna, an ICI spokesperson, suggested that the SEC enact and enforce a firm 4 p.m. (EST) cutoff for all mutual fund orders. Entries after the cutoff time would be transacted the following day.

Second, the trade group recommended that the SEC impose a 2 percent redemption fee on all mutual fund redemptions within five days of purchase. Studies show that the five-day wait would eliminate most, if not all, of the potential profits from rapid trading.

Broker/dealers might have to move up order cutoff times a little, but these proposals would not have much affect on the general community of advisors. “We might have an infrequent situation where a flood of small 401(k) orders came in and it took us awhile to sort out the paperwork,” said Ochs. “But if this solves the bigger problem of late trading, there’s a tradeoff.”

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