Index Funds Provide Hedge Against Dishonesty

Index mutual funds have gained a loyal following in recent years among investors who value such things as predictable performance, low costs and tax savings.

Now they may appeal to another group: people worried about unethical portfolio managers.

The recent scandal involving John Kaweske, a star manager for the Invesco Funds Group in Denver, has pushed managerial ethics into the limelight. Kaweske was fired for failing to comply with company policy requiring that he report and gain approval of his personal stock transactions.

The implication was that Kaweske was able to “front run,” or buy shares of certain companies before investing his funds’ money in the stocks, driving up their prices in the process. Kaweske’s ouster has caused some people to wonder how much preferential trading fund managers are doing for their own accounts. It’s an important question for the mutual fund business, which owes much to its reputation for high integrity.

But while such revelations are embarrassing if not downright painful for the people and firms affected, there’s no evidence of widespread abuse in an industry that now numbers about 5,000 funds. If anything, these types of problems make fund administrators, independent directors and federal regulators more vigilant, says A. Michael Lipper of Lipper Analytical Services, the performance-monitoring and consulting firm in Summit, N.J.

“I personally think the business is remarkably clean,” Lipper says, adding that there is no evidence so far that Invesco investors were harmed.

Even so, concerned shareholders need not worry in vain about their managers. They can reduce the chance of scandal by choosing index funds, a special type of portfolio with some important safeguards against abuse.

Index funds hope merely to replicate, not exceed, the performance of popular market benchmarks such as the Standard & Poor’s 500. This passive approach has several implications from an ethical standpoint.

First, index funds aren’t actively managed. The people who run these portfolios don’t spend their time researching companies in the hope of finding the next Microsoft or Intel. Instead, they’re obliged to invest shareholder money in a specific list of securities--the same stocks or bonds that make up the index they’re tracking. This straight-and-narrow focus reduces the chances that a manager might steer the fund’s money into a favorite stock, because with indexing there’s no room for favoritism.

Another trademark of index funds is that they tend to have lots of stocks--500 in the case of Vanguard Index Trust 500 Portfolio, for instance. As money flows in, the managers are obliged to spread it among all the holdings, to keep the fund’s stake in each stock equal to that company’s weighting in the target index.

Consequently, each stock is bought in low concentrations, which reduces the odds that managers will bump up the price by their purchasing actions. “We’re not going to move the market with 1,000 shares of anything,” says Gus Sauter, a Vanguard vice president who oversees the company’s 10 index funds.

Finally, many index portfolios focus on blue-chip benchmarks such as the S&P; 500, made up of the largest and most efficiently priced stocks--the ones that are the hardest to manipulate. These aren’t the types of companies likely to be targets of front-running. The most vulnerable investments are initial public offerings, small companies, growth stocks and less-liquid bonds, says Lipper.

Even without these managerial safeguards, index funds can make sense for other reasons. The fact that the funds can be expected to match the market--or at least an important benchmark--gives investors a degree of predictability.

Also, because index fund managers don’t actively trade their stocks, they typically cling to their core positions for years on end. This provides a tax-deferral angle on holdings that have risen in price. The reason: Mutual funds aren’t required to pass along their capital gains to shareholders--in the form of a taxable distribution--until they actually sell securities.

Finally, because index funds choose from a cut-and-dried list of stocks or bonds, their management expenses tend to be low, which translates into higher returns for shareholders.

On average, index funds can be expected to deliver a yearly cost advantage of 0.5% to 1% compared to rival portfolios.

The Franklin Group, which for years was one of the few large mutual fund families to impose a sales load on reinvested dividends, says it plans to change that policy.

Subject to shareholder approval, the San Mateo, Calif., firm will drop the load on reinvested dividends on all funds this spring. Instead, the company will impose small “12b-1” marketing fees ranging from 0.05% to 0.25% a year, depending on the fund. (The 12b-1 fee is sanctioned by the Securities and Exchange Commission rule from which it takes its name.) In addition, the onetime, front-end load will increase by between 0.25% and 0.5% for most portfolios.

For Franklin California Tax-Free Income, a huge portfolio that accounts for $14 billion of the group’s $73 billion in total fund assets, the maximum front-end load will rise to 4.25% from 4%. An annual 12b-1 fee of 0.05% will be imposed on existing accounts, 0.1% on new ones.

*

Peter Lynch, the celebrated former manager of Fidelity Magellan and currently a trustee for Boston-based Fidelity Investments, is giving a thumbs-up to financial and petroleum stocks for 1994.

Interviewed in Fidelity’s Mutual Fund Guide newsletter, Lynch says he likes Smith International, Enterra, Murphy Oil and Apache among energy firms. His other favorites are financial plays: Citicorp, Chemical Bank, Aflac, Kemper, Life USA, North Side Savings Bank and Fidelity New York (a bank unrelated to the fund giant).

An Index Fund Sampler

Here are some of the more promising index mutual funds available to smaller investors. None of these funds carry sales charges. Name: People’s Midcap Target index: S&P; MidCap 400 Phone (800): 645-6561 Comments: Dreyfus product that has beaten S&P; 500 during its three-year existence. *Name: Portico Immdex Target index: Lehman Bond Index Phone (800): 228-1024 Comments: Placed in top half of corporate bond funds each of its four years. *Name: Schwab Intl. Target index: 350 foreign stocks Phone (800): 526-8600 Comments: New fund offers relatively low-cost investment in foreign portfolio. *Name: Vanguard Bond Target index: Salomon Index Phone (800): 662-7447 Comments: Placed in top half of corporate bond funds for the past six years. *Name: Vanguard Trust Target index: S&P; 500 Phone (800): 662-7447 Comments: Beat rival growth-and-income portfolios each year from 1983 through 1991.