Avoiding Mutual Fund Fraud

Mutual funds can be very effective in portfolio management. They are managed by a fund manager and staff who spend their full time researching the stock market. Furthermore, mutual funds consist of a number of stocks so that even if one stock or sector of the market does not fare well, that one stock or sector will not drastically pull the entire mutual fund portfolio down.

There are many different mutual fund companies, each of which have a variety of funds to choose from. These companies offer funds from the very conservative to the very risky. Many companies also offer funds focusing on specific industries such as finance, technology and healthcare, etc. Within each specific sector, there can be several funds which run the gamut from very conservative to very risky.

When choosing a mutual fund, one should look at the past performance of the fund manager and the past performance of the fund. One should keep in mind that past performance does not mean that the fund will do as well in the future, because future performance depends on many variables.

Churning Mutual Funds
Investors generally purchase mutual funds as part of a long term investment strategy. However, the investor or his or her stockbroker, may decide that because market conditions have changed, that particular mutual fund may no longer be appropriate, and a different fund should be chosen. If the investor switches to different funds within the same mutual fund company, there are generally no additional commissions to be paid.

Most mutual fund companies offer a large selection of mutual funds and a number of appropriate choices should be available without the need to purchase a fund from a new mutual fund company. However, if the investor does choose to sell the initial fund and purchase a fund from a different company, the investor will pay a new commission or other fees.

Sometimes stockbrokers will suggest that a client switch to a completely different company even when the initial company had suitable investment options available. Sometimes they may recommend that an investor switch again and again to new companies in order to generate new commissions. This practice is a type of fraud known as churning an account. All investors should be wary of this.

Break Point Fraud
When choosing a mutual fund, remember that the more that you purchase from a company, the lower the commission percentage you will pay. For example, if you purchase $1.00 to $25,000, there may be a five percent fee. If you purchase $25,001 to $50,000, the commission would drop to four percent. From $50,001 to $100,000, the commission might drop to three percent. These cut offs are called "break points". Generally, an investor can purchase a combination of different funds within the same mutual fund company to reach the next lower break point level. For example, if an investor purchases two funds from the same company for $26,000 each, the investor would be considered to have purchased $52,000 for break point purposes, and will pay a lower commission than he or she should have if that investor had only invested $26,000. Your stockbroker should tell you about this concept so that you invest in fewer fund companies and pay less in commissions. When a stockbroker recommends that an investor purchase small amounts in many different companies without any justified reason, instead of placing the investor in a few fund companies, that stockbroker is earning far higher commissions that he or she should have. This is known as breakpoint fraud and the investor should be wary of this practice.

The Prospectus
Mutual fund companies and brokerage firms should give a prospectus to an investor when he or she wishes to invest in a mutual fund. The prospectus discusses in detail the past performance of the fund and provides information such as commissions, costs and redemption fees. It will also provide information as to what the fund invests in and how conservative or aggressive the fund is. Investors should thoroughly review each prospectus before making a mutual fund purchase.

"A" vs "B" Mutual Fund Shares
Mutual funds and brokerage firms receive compensation for the sale of mutual funds in the form of a commission or an administrative fee. Mutual funds can be purchased either as a class "A" share or a class "B" share. When an investor purchases a class "A" share mutual fund, he will pay a 1% to 5% commission upon the purchase of the shares, and will also generally be charged a 1/4 percent annual fee known as a 12(b) administrative fee. If the investor at any time wishes to sell the mutual fund or desires to switch within a mutual fund of the same company, there will be no additional fee.

When purchasing class "B" shares, the investor is not paying an up-front commission but is charged an administrative 12(b) fee of up to 1% yearly. Investors do not get the benefit of break points with "B" shares. Also importantly, the investor is required to hold onto this class of fund for a five or six years, depending upon the specific fund, or he or she will be charged a surrender fee. This surrender fee may be as high as 6%, depending upon how long the investor owned the fund before surrender. For example, if the investor redeemed a class "B" fund after one year, there may be a five percent redemption fee. If the investor redeemed a class "B" fund after two years, there may be a four percent redemption fee, while if the investor redeemed a class "B" fund after six years, there would be no redemption fee. Keep in mind though, that if an investor had purchased an "A" share, that investor may have received a lower commission depending upon the dollar amount purchased and therefore even if that investor needed to sell the "A" shares, the commissions would have been lower. Therefore, the "B" share will ultimately cost more in commission than the "A" share. Also keep in mind that the 12(b) fees for the "B" shares is higher than the "A" shares, thus the "B" shares will ultimately cost the investor much more than "A" shares. Because complex computations are required involving compounded interest on saved up-front fees, and the variable redemption fees of class B shares, it is beyond the scope of this brief review to further discuss the advantages and disadvantages of individual class "A" or class "B" shares within an individual fund. The investor is urged to read the prospectus to make the proper investment choices.

No Load Funds
Some mutual fund companies charge no commissions for the purchase or sale of their own funds. However, these companies sometimes will charge a higher 12(b) fee and may also have additional administrative costs that one would not pay by investing in a load fund. Investors must compare market performance, the fund manager's performance, and the total fees being paid for a given no load fund and compare it with the cost of a similar load fund before making a purchase decision.

Brokerage Firm Proprietary Funds
Brokerage firms sell their own proprietary mutual funds. For example, Merrill Lynch has its own line of mutual funds. Stockbrokers may be offered more incentives to sell their own brokerage firm's funds because they receive additional commissions or other incentives. Investor should ask their stockbroker what additional incentives they are receiving by selling their own brokerage firm's mutual funds. When an investor purchases a brokerage firm's proprietary fund, if that investor later decides to transfer his or her account to a different brokerage firm, the investor can not transfer the proprietary fund to the new brokerage firm. Instead, he must first sell it at the original brokerage firm and then purchase a different fund at the new brokerage firm. This is not the case with non-proprietary mutual funds, which like stocks, are somewhat more transferable. Hence, unnecessary fees, commissions, or other administrative costs may be paid out by an investor who purchases a proprietary mutual fund and later changes brokerage firms.

Pat's Problem
Pat went to a stockbroker for advice because she had finally made the decision to do something about her finances. She told the stockbroker that she was interested in a long term investment. The broker recommended that Pat invest in mutual funds. He also recommended that Pat split her monies into six different mutual fund companies, which she did. What the broker did not tell Pat was that had she placed all of her funds into one or two mutual fund companies, she would have saved thousand of dollars in commissions because she would have reached the next break point level. The broker also recommended that she invest part of her funds in B shares and told her that there was no commission to be paid in B shares. What he did not tell Pat was that she would pay substantially higher administrative fees each year by investing in B shares and would have to stay in this B share investment for six years or would pay surrender charges if she sold the B shares. When I analyzed Pat's account with her new stockbroker, we determined that had Pat been placed in one or two family of funds and would have been placed in class A shares instead of class B funds, she would have saved thousands of dollars.

I brought an arbitration on behalf of Pat and successfully obtained her money back for her.

In Conclusion
Mutual funds can be an important component of a balanced investment strategy providing the investor understands the general concepts governing commissions, fees, and other costs involved in their purchase, ownership, transfer and sale.

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