Be on the Watch for Turkeys That Might Gobble Up Your Investment

This is the time to hunt for turkeys--even in the mutual fund business.

Although the fund industry generally enjoys a reputation for playing fair and has been free of scandal for years, a few undesirable--yet legal--practices continue. Most work to the benefit of fund management companies or brokers that market these products, rather than investors. Here are some of the problem areas cited by independent fund watchers:

* 12b-1 charges. These fees, which are levied gradually over the course of a year by some funds to cover advertising and promotion costs, have drawn criticism for years. “I hate 12b-1 fees as a hidden kind of cost,” says Melvin Gladstone, a financial planner in Berkeley. If a fund carries a 12b-1 fee, it will be stated in the prospectus, so technically it’s not a hidden charge. But investors often don’t read the prospectus--a legal document of disclosure--carefully.

Don Phillips, editor of Morningstar Mutual Funds in Chicago, objects to 12b-1 fees on bond and money market funds in particular because he fears that managers may have to take bigger risks to offset the fees and keep their yields competitive.

Of course, the impact of a 12b-1 fee depends on its size. An annual charge of 0.25% or less is obviously much less of a burden than a 1.25% yearly fee, the maximum allowed by the Securities and Exchange Commission.

* Flat or rising expenses on growing funds. Mutual fund assets have surged to nearly $1.3 trillion today from $240 billion 10 years ago. Yet the economies of scale that many funds realized as they grew haven’t always been passed on to shareholders, Phillips says.

He attributes this to reluctance among fund companies to cut management fees, a key component of fund expenses, and investor apathy about doing anything about it. “Investment management is one of the most profitable businesses in the world,” he says, contending that profit margins of 40% to 50% are common.

A mutual fund’s yearly expenses, including management fees, show up in the “expense ratio,” a number reported in the prospectus. Look for ratios of 1.4% or below on stock funds and 1.1% or less on bond funds, Phillips suggests.

* Sales charges on reinvested dividends. Usually, investors who buy mutual funds through a broker pay a load only once--either up-front or upon redemption. But a few fund families charge shareholders not only at the time of purchase or sale but also when dividends and capital gains are reinvested.

Over time, this can drag down a fund’s performance and might even persuade some investors that it’s better to spend income when received than put it back to work for long-term growth. “Even if you use load funds, you wouldn’t want one that carries a load on reinvesting,” warns Glenn D. Woody, a financial consultant in Costa Mesa.

* Unannounced management changes. When Peter Lynch last year decided to step down as portfolio manager of the highly successful Fidelity Magellan Fund, Fidelity quickly divulged the news, and it received widespread coverage in the financial press. At some groups, personnel changes happen much more quietly, and investors might not find out who’s in charge for weeks or months.

“I don’t like situations where the manager leaves and the public doesn’t get the information quickly,” Gladstone says. “You buy a fund based on the track record built by the manager.”

If you’re worried about personnel turnover, consider an index fund, Gladstone suggests. Most are essentially unmanaged portfolios, because they merely hold the same stocks or bonds that are included in the market index or average that they track. A portfolio run by a team or committee might also make sense, as the manager who leaves can be more easily replaced. However, Gladstone doesn’t like this approach because he believes that consensus decisions often lead to mediocre investment results.

* Muddled shareholder communications. Investors stay informed about their mutual funds’ progress through quarterly, semiannual or annual reports; at least, that’s the way it’s supposed to work. In reality, some companies produce “lifeless” shareholder reports that either don’t offer much insight into how the fund is doing or try to turn every investment gain into a marketing pitch, Phillips charges. “Many groups don’t give much information, don’t own up to their mistakes or fail to explain their achievements in the proper context.”

His publication rates shareholder reports for frequency, timeliness, completeness and disclosure. In particular, investors should look for a letter to shareholders within the report that provides a candid discussion of the fund’s successes and failures, he says.

Phillips even believes that there’s a connection between better performing funds and those with quality shareholder reports, whether because these portfolios try harder to satisfy shareholders or simply don’t have as much to hide. “While some good funds issue bad reports, few . . . bad funds issue good reports,” he says.

Telling It As It Is One of the worst practices of some mutual fund companies is producing dull, vague and infrequent shareholder reports, says Don Phillips, editor of Morningstar Mutual Funds, a Chicago-based research publication. That’s why his company now grades these reports on how candid, timely, complete and visually attractive they are. On a scale from A (best) to F, here’s how Morningstar rates the 25 largest fund groups, listed according to size.

1. Fidelity (regular funds) B- Fidelity (select funds) C- 2. Franklin D 3. Vanguard A 4. Putnam B- 5. American B 6. Dean Witter D 7. Merrill Lynch A 8. IDS C+ 9. Dreyfus C- 10. Prudential C 11. Shearson Lehman Bros. D 12. Kemper C+ 13. T. Rowe Price A- 14. American Capital C+ 15. MFS C 16. Templeton B 17. Investment Portfolios C+ 18. United C+ 19. Pioneer C+ 20. Colonial C 21. Lord Abbett B 22. Federated C 23. Keystone B- 24. Twentieth Century C+ 25. Oppenheimer B-