November 5, 2003

November 5, 2003 | Commentary on Regulation

Let's Not Overreact

All financial scandals are not the same, and the problems affecting mutual funds are not those of Enron or WorldCom. No one has looted a company of billions of dollars, and no one is facing a retirement in poverty because the value of his or her investments has dropped to nothing.

The mutual fund scandals require a firm and direct response that includes firing the people responsible, leveling stiff fines and perhaps revising some of the laws that govern mutual funds. Already, several company presidents have been forced out with ruined reputations, and more will follow. But it would be wrong to blow this scandal out of proportion and to assume that it proves that mutual funds are risky places to invest, or that they need extensive new regulations.

Some are pushing for regulations of fund boards similar to mandates they would like to force on company boards. Both rely on the false assumption that boards, not management, are to blame for recent abuses.

Instead of theft, the mutual fund problems revolve around ethics. One in 10 companies allowed big and favored customers to buy shares at today's prices after the legal deadline. In a rising market, they got an extra day of profits that you or I would not have. It is illegal and unfair, but did not cost small customers more than a few cents.

There also is the issue of market timing - an investment strategy one of my business professors called an "idiots' delight." It involves very short-term purchases designed to cause profits when the market is going up. It is similar to playing roulette and betting on red. It is less risky than betting specific numbers, but only just. Because mutual funds set prices only once a day, the odds of winning are a bit better, but the main damage to small investors comes if this betting causes higher expenses. It is not even always illegal. Most of the violations the Securities and Exchange Commission found had to do with firms' breaking their own rules, not federal laws or regulations. Already, they are fixing the problems. Guilty people are being fired.

But the real damage that could result from this scandal might come from the supposed reformers. They are trotting out pet theories and reforms, many of which have nothing to do with the actual problems.

One of the reformers, New York Attorney General Eliot Spitzer, says he wants companies to give back the management fees they collected - potentially billions of dollars. This is far more than just paying back profits. These fees are the revenues that pay rent, employee salaries, legal advisers and other expenses. His plan would weaken mutual funds and cost smaller investors real money by causing much higher fees in the future.

This scandal requires an appropriate response, but the key word is appropriate. Let's not get carried away.

David C. John is a senior research fellow for Social Security at The Heritage Foundation.

About the Author

David C. John Senior Research Fellow in Retirement Security and Financial Institutions
Thomas A. Roe Institute for Economic Policy Studies

Reprinted with permission of USA Today.