Underlying the mutual fund scandals is an investment instrument that had already been made obsolete by technology for some investment applications. Over the last decade, mutual funds have become a more hidebound, self-serving industry that has generally ignored consumers' interests and innovations occurring elsewhere in financial services. The trading scandals reveal fundamental problems with the mutual fund structure that can't be fixed quickly and probably aren't worth fixing anyway, because next-generation technology is already superior.

Perspective on the Mutual Fund Industry

The U.S. mutual fund industry's 80-year history represents a phenomenal run. For decades, mutual funds have made diversified portfolios and professional management accessible to anyone with money to invest. During the 1970s and 80s, mutual funds were among America's most innovative industries. Managers like Peter Lynch and John Templeton became legendary based on their personal acumen for picking emerging trends and individual stocks. Without mutual funds to pay the bills, we wouldn't have thousands of qualified CFPs dispensing valuable professional advice to American households. Mutual funds are still the best vehicle for offering broadly diversified investment menus to millions of retirement plan participants, and they remain viable in helping young and middle-class investors gain their first experience in the market.

But during the 1950s, the U.S. railroad industry floundered by failing to realize that it's real product was transportation, and that innovations were occurring in transportation that would render large segments of the railroad infrastructure obsolete. Likewise, the mutual fund industry should realize that its real product isn't mutual funds-it's professional investment management and research. Opportunities now exist to offer this product in more efficient structures that are less costly and vulnerable to manipulation than mutual funds. These new-wave structures-including separate accounts, folios and exchange-traded funds (ETFs)-all take advantage of ideas and technologies that did not exist ten years ago.

A Run on the Bank

There has always been an underlying structural problem with mutual funds, masked for 40 years by steady asset growth. Now, with the first true "run on the bank" ever experienced by a major mutual fund group (Putnam), this problem has become apparent even to Main Street investors.

The last person you ever want to be on Wall Street is the trader who is forced to sell billions of dollars of securities overnight to raise liquid funds. In my May column, I called attention to the research of institutional money manager Theodore R. Aronson, indicating that an average roundtrip trade by an equity mutual fund costs 2.2% of the amount traded, and this is an "invisible cost" not reflected in the published expense ratio. But that's in a normal market. When the sharks on Wall Street smell the blood of a mutual fund group forced to redeem vast quantities of shares immediately, the invisible trading costs rise.

In any run on the bank, nobody wants to be the last person standing in line. In this case, it isn't a matter of whether money will be repaid. Rather, the last investor in line at Putnam must absorb the redemption-driven trading costs (and possibly the tax consequences) of all investors who bailed out before. Of course, thousands of ethical financial advisors are pulling their hair out right now trying to advise Putnam investors what to do. (My deepest sympathies and best wishes to you all. My main advice is that you not procrastinate. Whatever guidance you have to offer Putnam investors, do it now!)

In terms of cashflows, the mutual fund industry still has one saving grace. Each month, it receives net inflows estimated at about $10-11 billion from retirement plan contributions. Aside from a few fund groups linked to the trading scandals, this cash should continue to flow for a while. But defined contribution plans, in total, account for only about 15% of total mutual fund assets, and the rest of the industry's assets now appear more vulnerable to future redemptions. As Baby Boomers begin retiring and moving their 401(k) money into IRAs, will they stick with mutual funds after this scandal has played out its last sour note? Many won't. I predict that net cashflows for the mutual fund industry as a whole will be sharply negative for the next year or two and then flat to modestly negative for several years after-as more investors discover separate accounts and other alternatives for IRAs and non-qualified money. In that environment, mutual fund trading costs will rise, especially at groups experiencing the largest net cash outflows.

There is a simple and obvious way that mutual funds could cushion the trading costs of net cash outflows-namely, hold more cash to meet redemptions while actively managing cash levels to reduce trading costs and boost returns. You would think that a fund group that spends millions of dollars hiring the best research and management minds could find ways to add value by managing cash levels, but few even try. The main reason: Historically, the stock market has increased in twice as many months as it has fallen. On average, high cash levels produce a drag on performance, and in this area mutual funds are happy to "play the averages" rather than actively manage assets. Playing the averages may have been a valid policy during a 40-year era when mutual funds could raise all the cash they needed from net inflows. Now, it needs rethinking.

Other Embedded Problems

Mutual funds have other embedded problems exposed by these scandals.

• Mutual funds can't join the trend toward greater portfolio transparency because of their vulnerability to trading manipulation. It would be nice if fund investors could monitor changes in fund portfolios on a real time basis, as they can in separate accounts. But imagine how devastating it would be to Putnam's investors if every Wall Street shark knew every portfolio position?
• Mutual fund investors aren't even close to having the fiduciary protections that ERISA affords retirement plan participants. Most directors work for several different funds in the same complex, and this creates inherent conflicts-of-interest. One disturbing trend that none of the regulators have yet mentioned is directors' influence to transfer large amounts of assets between funds through fund-of-fund structures, asset allocation programs, rebalancing events, etc. How would you like to invest in a mutual fund that gets socked with thousands of dollars in trading costs to benefit the rebalancing program of a fund-of-funds-then learn that your fund's directors also sit on the fund-of-funds' board? That type of conflict-of-interest could not legally happen to an ERISA plan participant, due to rules requiring fiduciaries to make decisions solely in the interest of their own investors.
• Several manipulative tactics now in the crosshairs of regulators result from the mutual fund industry's once-per-day pricing model. Separate accounts and ETFs don't have this problem. They are priced and traded in real time, and now investors better understand the value of this benefit.
• In addition to investors, the real victims of these scandals are thousands of honest and hard-working mutual fund portfolio managers. For every dollar that a manipulative trader drains from a fund's performance or adds to its costs, the manager must work that much harder to produce performance. It's remarkable that some fund managers have outperformed benchmarks over long periods when they were sailing into the headwinds of these costs. But achieving that performance will become even more difficult in an era of flat-to-negative cashflows. Expect the mutual fund industry to experience a talent drain as the best managers leave for separate accounts, hedge funds, folios and other structures in which performance isn't constantly dragged down by hidden costs.
• At some fund groups, the quest for active management by brilliant individual managers (like John Templeton and Peter Lynch) has given way to management-by-committee and a desire to always stay one quintile above average. As much as these scandals have cost mutual fund investors, it's a drop in the bucket compared to the cost of closet-index strategies that charge high management fees. Regulators have limited power to regulate high mutual fund costs that are clearly disclosed by prospectus. However, financial advisors can play an important role in fund cost comparisons, and more advisors are assuming that role.

What Should You Do?

• Don't let your practice become a victim of closed-minded thinking, like the railroad industry in the 1950s. Keep your mind open to innovations in financial services. For each client, consider which structure (mutual fund, separate account, ETF) meets personal investment objectives.
• This is a good time to discuss separate accounts with your mutual fund investors who are disturbed by the scandals. The prime market for separate accounts is long-term investors holding non-qualified funds or personal IRAs worth $50,000 or more. The larger a client's assets, the more attractive separate accounts look compared to mutual funds.
• Add these issues to your mutual fund due diligence process: 1) Recent patterns in a fund's net cashflows; 2) Recent trading costs; 3) Policies regarding fiduciary responsibility of directors; and 4) Comparison of active management value added vs. management fees earned. Let clients know that your role is to help them evaluate these areas and then monitor them on a continuing basis.
• This is also a good time to prospect among small business retirement plans in your market, to see if decision-makers are troubled by the involvement of their fund providers in these scandals. (See related article.) In most cases, mutual funds are the best investment structure available for small business retirement plans. But you can show plans that your due diligence process has identified better mutual fund groups than those now serving the plan, and you can also help plans reduce vulnerability to any single fund group's problems.
• Consider the cost of the time you must spend performing due diligence on mutual funds, compared to simpler alternatives like separate accounts and ETFs. Your time is valuable and clients should compensate you for it. You may conclude that for some types of clients, you can't afford the time required to dig into complex issues such as how mutual funds supervise trading activities or appoint directors.
• Use the table below to help clients compare benefits of alternative structures.
• Don't tie your own fate to that of mutual funds. Don't make blanket statements like The New York Times did: "Mutual funds remain the best way for individuals to invest in the stock market." Even if you have believed that idea in the past, it's not productive thinking today. Mutual funds remain one important way to access diversified investment programs with professional management. The role of a professional financial advisor is to help clients evaluate all ways that can meet their personal needs.