Many investors believe that they can avoid the kind of fraud perpetrated by Enron, WorldCom and other issuers of stock by investing in mutual funds instead. A mutual fund is a fund of different stocks (or other type of assets such as bonds), which are split into fractions, or shares, and sold to the investing public. While it is true that owning a truly diversified mutual fund is less risky than owning a single stock or just a few stocks from the same industry, a mutual fund is not necessarily a safe haven. It is important to know all the important characteristics of the fund you own -- such as the kinds of assets it will own and what its true costs are. In failing to explain these and other circumstances to a mutual fund buyer, the companies that issue mutual funds and the brokers who sell them often engage in fraud.

Here are a few examples. Sometimes investors are encouraged by their brokers to invest in a special class of funds commonly called "B Shares." The investors are not told, however, that if they purchased the regular shares, or A Shares, their total costs would be less because they would be entitled to commission discounts, called "breakpoints," from the issuer. By failing to explain this to you, your broker can pocket more of your hard-earned money!

Another, more common type of fraud associated with B Shares is the failure to explain all of the non-commission expenses. B Shares are attractive to most investors on the surface because, unlike A Shares, they carry no up-front commission. Many brokers will simply tell you they cost less, but that not always true. There are two additional charges that are often not adequately explained. One is a 12b-1 fee, a special charge the issuing company uses primarily to offset its marketing costs. The other is a "contingent deferred sales charge," which you only pay if you fail to hold your shares for a predetermined period, say five years. The total of these two charges will exceed the commission you would have paid to buy the A shares. The vast majority of investors would have made much more money by paying the regular commission up front and buying the A shares.

There are many other ways you can be defrauded into buying a mutual fund:

Your broker, and sometimes the fund issuer's own prosepctus, can mischaracterize the type of stocks in which the fund will invest. Many investors lost a lot of money in the early 2000s by not being told that the particular fund they owned was heavily weighted in technology or telecommunications stocks. The broker should explain that there are different types of diversification; merely owning "diversified" assets of the same class and subtype, say all small cap stocks or all technology stocks, will hardly protect the investor weather the storm when that class of stock as a whole declines. What most investors truly need for purposes of diversification are mutual funds that, taken together, are diversified among different asset classes -- think stocks and bonds -- and then are further diversified with different subclasses of stocks and bonds, such as small and large cap stocks from diverse industry sectors. Because setting up this kind of portfolio is usually less profitable to the broker, many investors will never get this kind of advice.

Another example of mutual fund fraud is a scheme known as "market timing." Many large preferred customers of broker/dealers sometimes get a special deal: They can purchase after the market closes at yesterday's price, already knowing that the shares can be unloaded tomorrow for a profit. One company -- Bear Stearns -- falsified order tickets by recording orders that actually took place after 4pm. Other customers were given direct access to Bear Sterns mutual fund order entry system, allowing them the ability to trade until 5:45pm. Even more disturbing, Bear Sterns helped some customers cancel unprofitable transactions the next day. The cost that is passed on to you the individual investor is minimal, but you should at least be told that a small part of your profits will be skimmed off to pay the participants in this illegal scheme.

Sometimes an investment advisor or broker will not explain to you that the reason he is recommending a particular mutual fund to you is that the fund pays commissions and other fees to his broker/dealer. Sometimes this amounts to a kickback -- a quid pro quo payment for recommendation. Even if the payment to the broker/dealer is a legitimate payment for commissions for trades placed for the fund, the failure to explain this is a fraud since many investors would immediately perceive a conflict of interest and look for a fund that will cost them less.

In summary, mutual funds are not safe havens. Like stocks, they are sometimes sold to investors through fraud, deceit, or trickery. You are entitled to know every material fact about your investment in a mutual fund, and if something was not explained, you can recover your losses through arbitration or, in some cases, court action.