Old-Guard Funds Return to Favor

Amid the worst scandal in the modern mutual fund industry’s history, it would be understandable if much of the investing public simply cashed out and went back to their local banks.

Who needs this grief, after the gross misconduct of so many companies and Wall Street brokerage firms in recent years?

Yet last week, when the fund industry’s chief trade group reported on investor activity for October, the net money inflow to stock funds was given as $25.5 billion. It was the biggest monthly haul of fresh cash this year.

In part, the industry may be just plain lucky the scandal broke when it did -- six months into the most powerful stock market rally since the late 1990s.

There’s no question that many average investors are ticked off about the allegations of widespread trading abuses at equity funds, including blatant self-dealing by some portfolio managers and favors granted to well-heeled clients at everyone else’s expense.

But it’s hard to leave a good party. Even if you own a fund managed by a company implicated in this mess, if the portfolio has performed well this year, you’re likely to think twice about jettisoning it.

The average U.S. stock fund is up 27.5% year to date, according to Morningstar Inc.

But there’s another reason the overall industry data don’t show the public fleeing long-term funds in droves: Even before the first case in the scandal was announced Sept. 3 by New York Atty. Gen. Eliot Spitzer, investors had become much choosier about which fund companies deserved their dollars.

According to Financial Research Corp. of Boston, the bulk of the net cash inflows to stock and bond funds this year have gone to companies that have reputations for corporate integrity and for solid long-term performance -- including the American Funds group in Los Angeles, Vanguard Group in Valley Forge, Pa., and Dodge & Cox funds in San Francisco.

Of the 10 fund companies that have taken in the most new money this year, just one -- the One Group funds in Chicago, operated by Bank One Corp. -- officially has been implicated in the fund scandal.

Meanwhile, well before fund companies including Putnam Investments and Janus Capital Group had been implicated, they had been suffering net outflows of cash this year primarily because of poor portfolio performance.

The cash-flow trends in large part reflect the general conservative shift many investors have experienced in the wake of stocks’ deep bear market. American Funds and Dodge & Cox, for example, have long championed a “value�-oriented approach to investing. That style was a flop in the late 1990s amid the dot-com boom, but it has flourished again in recent years.

Cynics might say investors -- or their financial advisors -- are merely chasing what has been working well recently. There is doubtless something to that.

Still, in this environment, it’s difficult to take people to task for sending their savings to more conservative fund firms. There are a lot of worse ways to invest.

There’s another advantage many of those old-guard fund companies provide: The fees they charge investors for managing the portfolios are in many cases below industry averages.

Vanguard, of course, has long been the lowest of the low-fee fund firms. For example, the company eats up less than 0.2% of its popular 500 Index fund’s portfolio value each year in management costs. Some of its rivals charge 0.5% to 1% to manage similar index funds. Those expenses come directly out of investors’ returns.

If people focused only on fees, Vanguard might end up with nearly every last mutual fund dollar. That hasn’t happened, because fund fees must be considered in the context of other factors that influence how someone chooses one portfolio or decides to stay with another.

It’s easy to rail generically against funds with “high fees.� But an above-average portfolio management fee -- say, 2% a year -- may be quite acceptable to investors if the fund’s performance consistently beats its category average.

In other words, if you’re getting what you pay for, so what if the fee appears high? Tickets to Lakers games cost more than tickets to games of inferior teams. That isn’t unjust.

The trick is to find funds that can do both for long periods -- beat the averages even with above-average expenses. It’s not an easy task.

Investors also may be willing to shoulder high fund expenses if the cost primarily is going to pay a financial advisor for help.

As detailed in last week’s column, many funds assess so-called 12b-1 fees each year, eating up as much as 1% of portfolio value, mostly to pay brokers for their work in selling funds and monitoring them for investors. The fees are spelled out clearly in fund prospectuses, if investors would bother to read them.

American Funds, the most popular fund group this year, charges the full 12b-1 fee on the Class B and Class C shares of its Washington Mutual fund. That lifts the total annual expense ratio on the shares to about 1.5% -- certainly not cheap. But that isn’t stopping money from flowing into the fund. Either investors are judging the cost as fair, or they aren’t paying attention.

The mutual fund industry can be accused of many things these days, but lack of choice isn’t one of them. Investors who are willing to do their homework, and pick funds on their own, can easily find low-cost funds (without 12b-1 fees) that fit their needs.

But doing one’s homework also applies to investors who want or need a financial advisor’s help in choosing funds. If you aren’t clear on the costs you’re paying, or even if you think you’re clear, read the fund’s prospectus. You might be amazed at what you’ll learn -- including that you may have made exactly the right choice.

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Tom Petruno can be reached at [email protected].