The word 'dissonance' is probably most familiar to PerformInk readers as a musical term. But its broader sense describes what has gone wrong in the mutual fund industry: The interests of those running these funds often clash with the interests of the investors. A fund manager would need an almost saintly rectitude to unfailingly keep investors' interests above his own. Not surprisingly, the Pope has not beatified any fund managers. And when the manager is actually rewarded for hurting his investors, the temptation is nearly impossible to resist.

A Simple Shell Game

To understand that situation, you need to understand a little bit about how mutual funds work. Each fund is legally a separate entity, with a board of directors, which in theory hires the fund's investment advisers. (Of course, the advisers are the ones who created the fund and initially appointed the self-perpetuating board, so there is no real independence. But that's a different problem.) From the investors' money, the advisers receive a fee for their investment services, another for their administrative and management services, and often a third for marketing services. All of these are a percentage of the funds' assets, so as a fund flourishes and grows, so do the fees. In theory, this should roughly align the investors' interests with those of the advisers.

The advisers, though, have other sources of income, because they earn commissions when a brokerage firm customer buys mutual fund shares. Since there are more than 8,000 mutual funds, the management of many funds make deals with brokers: You push our funds, and we'll use your firm when these funds buy and sell stocks. This simple reciprocity may seem innocent, but remember that the cost of buying and selling stocks is paid by the investors, not the advisers. There is no guarantee that the brokerage firm will provide the best execution of the trades or charge the lowest fees. To the extent they don't, the advisers have taken money from the investors' pockets, and moved it to their own through a third party.

Surprisingly enough, this is legal. Morgan Stanley recently agreed to pay a $50 million penalty, not for buying brokerage volume this way, but for failing to disclose the practice to investors. I call it a kickback, but you can be confident that they will use a gentle euphemism when they do make that disclosure.

You can't be a 'little bit pregnant,' and it is mighty difficult to be a 'little bit dishonest.' I see only the slimmest ethical nuance between this and using the fund's nonpublic investment information to seek trading advantage for your own account (as Richard Strong and others allegedly did) or turning a blind eye to late trading.

Should You Bail Out Of These Funds?

Whatever I say here must be generalities, because every investor's situation is different; please consult your own financial advisers before making changes. If I personally owned shares in a mutual fund from a scandal-tainted company, I would have to consider whether the sale would have tax consequences. Shares held in a retirement account would be sold unhesitatingly. (Do not withdraw the funds if you do, as that will cause tax problems; have them transferred directly to the new fund company or other custodian.) If I had shares in a taxable account, I would calculate the gain, and see what losing positions I could sell to offset it. But I would probably sell, even if it cost me some taxes.

Even if no further problems ever emerge from that fund group'a highly doubtful scenario, I think'massive outflows are already occurring. These inevitably will raise costs and hurt future performance. And there are better funds to be found.

Being a Latter-Day Diogenes

No matter what regulatory action is taken, these conflicts of interest can and will continue to exist to some degree. As in any field, some companies have higher ethical standards than others, and obtain better compliance both through rule enforcement and their corporate culture.

Look for consistently good investment results, of course. Look for low costs relative to other funds with similar investment goals, and with low turnover of stocks. Look for mutual fund companies whose management has been consistently outspoken about keeping the focus on their investors, and that have been actively involved in addressing governance issues at the businesses they invest in rather than merely rubber-stamping the actions of the businesses' boards. Look for stability in management and a clear investment philosophy.

Most important from my standpoint, look for mutual funds whose operators invest with you. Here are two real statements from prospectuses, with names omitted. 'The Managing Directors of [the company] have always invested right alongside its clients. At March 31, 2003, the current and retired principals of [the company] and their families and [our] employees have more than $400 million of their personal funds invested in portfolios combined with or similar to their clients portfolios. We have always owned what our clients own.' Another: 'The X family, directors and employees of X Advisors have collectively invested more than $2 billion alongside our clients. We remain the largest group of shareholders in our investment products, which ensures that our interests are closely aligned with those of our clients.'

Say Amen, Someone.

Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.

Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He also sometimes produces theatre.

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