Good Funds Gone Bad

The finer points of late trading and market timing might be lost on the majority of mutual fund investors, even after months of scandal-bearing headlines, but the bottom line is not: Namely, that big investors were given breaks that hurt the little guy. Everybody can grasp that much, and securities regulators and politicians are frothing at the mouth to hold fund houses accountable. That's fine for them, but what should you do if you happen to invest in a fund that's been publicly tarnished by the growing scandal?

After all, it's not as if a fund is going to become worthless the way Enron Corp. shares did when the bottom fell out. A fund's net asset value (NAV) is calculated daily by adding up the value of its investments and dividing by the number of shares outstanding. Unless most of a fund's investments go bad all at the same time, its NAV won't drop off a cliff no matter what its parent company says or does.

Jordan E. Goodman, author of Reading Between the Lies: How to Detect Fraud and Avoid Becoming a Victim of Wall Street's Next Scandal (Dearborn Trade Publishing), is still adamant that investors should sell shares in what he calls "named funds." He says the fact that public pension funds and other investors are pulling their money from scandal-tarnished funds will lead to higher trade-related expenses, create taxable gains for shareholders left behind, and divert managers' attention from day-to-day money management. "It's going to be very disruptive to long-term shareholders," Goodman says. "There's a reputation risk to the fund going forward, too, which could hurt in terms of new talent and money coming in."

A problem with selling your shares willy-nilly, though, is that it could trigger tax headaches. If you've held shares for less than a year, any capital gains will be taxed at ordinary income rates up to 35 percent. Even longer-term capital gains can nick you for 15 percent of your long-overdue market winnings. Then, of course, there's the headache of figuring out what your tax basis was in the first place.

If you don't face serious tax consequences, however, it's a no-brainer. Slowly divest yourself of investments in fund companies that put their own profits ahead of yours. Even if you do face tax complications, it might be time to start trimming around the edges, transferring the least-painful blocks of shares to fund companies with a clean record.

Next month, we'll talk about one alternative: separately managed accounts.

Scott Bernard Nelson is an assistant business editor at The Oregonian and a freelance writer in Portland, Oregon.