Mutual Fund Fraud
Many investors believe that they can avoid the kind of fraud perpetrated by companies like Enron, WorldCom and other issuers of stock by investing in mutual funds instead. Mutual funds pool investors’ monies and purchase different stocks (or other types of assets such as bonds). 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 for an investor to know all the important characteristics of the funds the investor owns — such as the kinds of assets it will own and what its true costs are. If the issuer and the brokerage firms that sell the fund fail to explain these and other circumstances to a mutual fund investor, both may be engaged in fraud.
There are many ways investors can be harmed when buying a mutual fund:
- The brokerage firm, and/or the fund issuer (in the prospectus), can mischaracterize the types of investments in which the fund will invest. Many investors have lost lots of money by not being told that the particular fund they owned was heavily weighted in mortgages or alternative investments. The brokerage firm should explain that there are different types of diversification. Merely owning “diversified” assets of the same class and subtype, say all high risk small cap stocks or mortgages or alternative investments, will hardly protect the investor weather the storm when that class of investments as a whole declines. Even investors who own multiple mutual funds often learn that there is significant overlap among the funds and that there is far less diversification than the investors thought. What most investors truly need for purposes of diversification are mutual funds that, taken together, are diversified among different asset classes and then are further diversified with different subclasses of those asset classes. Because setting up this kind of portfolio is usually less profitable to the brokerage firm, many investors will never get this kind of advice.
- Sometimes an investment advisor or brokerage firm will not disclose to a investor that one reason they are recommending a particular mutual fund is that the fund pays larger commissions, incentives and other fees to the broker/dealer. Sometimes this is tantamount 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 can be a fraud since many investors would immediately perceive a conflict of interest and look for a fund that will cost less. In order to generate fees and commissions, some investment advisors have engaged in a form of mutual fund churning known by regulators as “switching.” Mutual funds are not considered trading vehicles and should not be bought and sold within short periods of time.
- Investors in exotic or concentrated mutual funds also often find themselves exposed to unusually high risks. Recently, alternative funds have grown in popularity due to claims that they add diversification to a portfolio by not being correlated with traditional investments. Alternative investment funds are often marketed as “market-neutral” or “long-short” funds that straddle and partake of both up and down markets. They have not, however, lived up to their hype. Figures reported by Morningstar show that investors in such funds would have been better off investing in U.S. Treasury bills. Like hedge funds, alternative mutual funds have a high cost structure compared with most U.S. equity mutual funds, and are higher risk in that many hold assets such as currencies, futures contracts, and concentrated short positions, which may subject the investor to unlimited losses if markets rise.
- Similarly, another popular investment packaged and sold by Wall Street has been focus funds. These are highly concentrated (undiversified) and extremely volatile equity mutual funds that are actively managed. As with alternative funds, their performance has not measured up to the hype. Focus funds may own fewer than 50 stocks or have more than 50% of their funds invested in their top 10 holdings. They generally have higher management fees.
- Mutual funds have experienced significant net outflows in recent years, showing that some of their attractiveness as new investments has diminished. As of September 2011, investors pulled $44.5 billion out of equity mutual funds and $10 billion out of bond mutual funds, with most of that going into FDIC insured accounts. These moves are in reaction to the extreme volatility in the financial markets which has impacted many funds. Mutual fund investors are not buying after significant sell-offs as they did in past years when housing prices were rising. The housing price crash that began in 2007 destroyed too much wealth. Moreover, members of the baby boom generation are becoming net sellers of risk assets as they transition into their retirement years and have reduced the demand for stocks, bonds and other investments. The extreme volatility has reportedly also deterred many younger investors from investing in mutual funds.
- In summary, mutual funds are not safe havens. Like other investments, 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.