Other Views: Advisers need to pick up warning signs when funds court trouble

Are mutual funds becoming so complicated that you need securities counsel and mutual fund accountants to help you pick funds for your clients? Not quite, but we may be headed in that direction.

Ten years ago, financial information providers typically reported little more than funds’ investment returns and a few risk measures. Now Wiesenberger is rolling out FundDirections, a web-based tool that evaluates funds based on more than 200 criteria.

But evaluating all of the quantitative criteria is easy compared with judging the impact of “soft” factors – such as pricing policies, board independence and trading practices – on a fund’s performance.

Consider the Heartland municipal bond funds that dropped 70% and 44% in one day last year because they mispriced their portfolios. In retrospect, there were many warning signs of their pricing problems.

The funds were drawing on a line of credit in an amount exceeding 13% of assets, were the highest-yielding muni funds in the 12 months before the crash, had more than 95% of their assets in non-rated obligations (more than 8% in default) and had sharply marked down the portfolios two weeks before the crash.

Before the Heartland fiasco, an adviser probably would not have been held responsible for picking up indications that the funds’ prices were suspect. Now it’s not so clear.

Heartland’s pricing problems are emblematic of the operational issues that increasingly will affect funds’ bottom lines and will be required reading for advisers.

In the future, advisory clients – and, more importantly, courts – may expect advisers to pick up on the warning signs and get their clients out of funds before disaster strikes.

A surprising number of those factors can affect a fund’s bottom line.

An example is arbitrage pricing. Many foreign funds use stale prices to value their portfolios, thereby exposing the fund to predatory arbitrageurs that buy shares at artificially low prices in the knowledge that they will rise the next day.

Arbitrage pricing can systematically drain a fund’s assets and can cause a one-day loss of 3% or 4%. Some foreign funds preempt arbitrageurs by updating their valuations when the fund is priced. Do advisers consider funds’ pricing policies when deciding whether to recommend an investment?

“Portfolio pumping” has the effect of inflating end-of-quarter fund net asset values. Once the Securities and Exchange Commission’s investigation of portfolio pumping appeared on the front page of InvestmentNews [Nov. 27], were advisers responsible for avoiding end-of-quarter purchases?

And once stories began appearing about certain exchange-traded funds trading at premiums or discounts, contrary to the claims of marketers, advisers arguably became responsible for ensuring that their clients did not buy at a premium, or sell at a discount, to the fund’s NAV.

Advisers may even need to evaluate the quality of a fund’s board of directors. An independent director for one of the Heartland funds was the investment adviser’s landlord, a fact that might have affected the director’s ability to oversee the manager’s pricing policies.

Funds will be required to report that kind of information beginning next year. Should advisers consider relationships between independent directors and fund management before recommending an investment in a fund?

Massachusetts and Maryland have adopted legislation that will curtail investors’ right to sue self-dealing directors for wrongdoing. All things being equal, should advisers counsel clients to invest in funds incorporated in Delaware?

The significance of these non-quantitative factors is growing, and advisers will increasingly be ex-pected to take them into account when evaluating mutual funds. And it’s not just a matter of advisers’ reputations and their client relationships. It’s also a matter of their legal exposure to financial liability for clients’ losses.

Legal liability often follows the “first bite” principle. You get a free pass the first time your dog bites someone, but the second time you should have known better. Accordingly, the next Heartland fiasco may yield not just claims against the fund’s manager, but also claims against advisers who failed to anticipate the fund’s meltdown.

On the whole, though, mutual funds are a relatively safe bet. They are subject to a pervasive regulatory regime that provides a high level of comfort regarding their operation. Indeed, those rules give mutual funds a significant, albeit underappreciated, advantage over pretenders such as folios, separate accounts and hedge funds.

Those alternative-investment pools are not subject to mutual fund rules covering such activities as corporate governance, borrowing, pricing, redemptions, performance reporting and transactions with affiliates.

Yet declining markets have a way of turning investors’ attention to the role of factors other than their own investment decisions. And with more of their money in mutual funds than anywhere else, fund policies and practices will likely receive an increasing amount of attention and become a fertile area for the plaintiffs’ bar.

Mercer Bullard, founder and CEO of Fund Democracy LLC, a Chevy Chase, Md., advocacy group, is a former Securities and Exchange Commission attorney.