Fund investigations: Should you sell now?

The mutual fund scandals keep coming at shell-shocked investors who wonder whether they should abandon the whole industry and put their money under a mattress. It all depends whether you own shares in funds of companies charged in the scandal. It is important to put the scary headlines in perspective. There are thousands and thousands of mutual funds. Only a few hundred, so far, have been accused of allowing questionable market timing to occur. Many of the major and smaller fund companies strictly prohibit market timing and take active steps to discourage or stop it. It is likely that they will come out of the current investigations with a clean bill of health and will continue to deliver professional investment services to shareholders at reasonable cost.

However, some companies apparently are in deep trouble with regulators and shareholders. If you own shares of funds issued by those companies, you should make an informed decision on whether to sell or hold. First, make a judgment as to how badly affected your mutual fund company is by the scandal. A company that is facing serious charges, and many defections by current investors, may give you lower investment returns because of shareholder redemptions.

Putnam, for instance, has seen billions of dollars flow out of its funds in the past few weeks. Such outflows make it difficult for a fund manager to invest, because he needs more cash on hand to handle redemptions. It can lead to higher fees and lower returns for remaining investors. “I think the biggest downside will be that other investors will sell out ahead of you,” said Jeff Tjornehoj, analyst for Lipper Inc., which tracks mutual funds. Companies facing serious allegations and shareholder flight currently include Putnam, Strong, Janus, Alliance, PBHG, Alger, Bank of America, Nations, Bank One, and Prudential.

Before selling a fund, an investor should check on the tax consequences and on any deferred sales charges. An investment loss taken now will help reduce current year income taxes. Investment gains will increase them; however, the new lower capital gains rates ease the bite. Some funds levy a deferred sales charge of up to 7% for shares sold within the first five to seven years of ownership.

Investors who sell probably should not stuff the money in the mattress. Instead, they should seek out a competing fund firm that operates ethically and in its shareholders’ best interests.