Buy, sell or hold those scandal-tainted mutual funds?
By Laura Bruce • Bankrate.com

Judging by the billions of dollars that investors continue to pump into stock mutual funds, it seems people are deciding that's where they want their money to be, even if the industry is tainted by an ugly sludge of greed and an apparent willingness to rip off customers.

But allegations, charges and, in some cases, admissions of guilt in one of the greatest shake-ups to rock the investment world have some consumers wondering if they should continue to stay invested in funds run by companies named in the scandal.

Tax-deferred accounts
If you're holding the funds in a 401(k), for example, there are a few things you should do, says Rick Meigs, president of 401kHelpCenter.com.

First, become informed. Find out whether you have any exposure to funds involved in the scandal.

"This is not a blanket indictment of the mutual funds industry," says Meigs. "Many fund companies are not involved."

If you do have some tainted funds, you might consider selling them if you're not comfortable owning them. But Meigs suggests taking a wait-and-see approach. As he points out, with an investigation that's growing every day, you could transfer your money from a tainted fund only to find your new fund in hot water a few weeks later.

Asset allocation is another consideration. Many 401(k) plans have just one option per asset class. If you sell a large cap value fund, you may not have a similar option in which to invest the proceeds.

Finally, talk to the plan sponsor. Ask what they're doing to protect your interests.

"The sponsor has a fiduciary responsibility to act solely in the interest of the plan participants and beneficiaries," Meigs explains. "They also have a duty to ensure that the options available to the participants are in the best interest of the participant. The sponsor must be informed about these issues. It's surprising how many are ignoring this, particularly in the smaller companies."

Taxable accounts
There's a lot more to consider when cashing out of a fund that's held in a taxable account. In addition to possible capital gains, there may be a redemption fee or back-end load. But staying with the fund can have unwanted consequences, too. If everyone else is bailing, you might not want to be left holding the bag.

"Generally, the larger the fund, the more assets it has, and the lower the expenses," says Rick Fingerman, a certified financial planner with Financial Planning Services in Medford, Mass., and chairman of the Financial Planning Association of Massachusetts.

"If a lot of assets are leaving, the expense ratio goes up. If a lot of people leave the fund, and the fund doesn't have the cash on hand, they have to sell shares in the portfolio. They may sell a million shares of Coca Cola to raise the cash. That tends to drive down the share price, so your account is now worth less.

"If you have institutional type money that's leaving by the billions, the average small investor says, 'All I have is $20,000 and I can't afford to lose that.' Then they stick it in the bank and that's no good either. If they have a long-term horizon they should be in stocks."

Russell Kinnel, director of mutual fund research at Morningstar, points out that buying another fund may mean paying a front-end load. But Kinnel says there are very good reasons to sell some of the tainted funds.

"It's not simply that you don't like a fund; it's the risk-reward. When we make a recommendation, it's based on what our outlook is, not what good or bad things the fund has done in the past.

"We would sell Alliance, Janus, Bank One, Nations Funds, Alger and Strong. We're saying don't send new money to Putnam. Take Alliance, it's just not a very attractive risk-reward profile. They have some very high-cost funds and there's compliance risk. In Janus and Putnam, you have a lot of disarray in their investment growth, there's compliance risk and they've had poor performance. They have a lot of work to do to fix things up, and generally, that points to a flawed corporate culture -- not a thing you fix overnight."

But, Kinnel cautions, investors should consider taxes and other costs involved before selling a fund.

Other considerations
Sometimes, it may be hard to stomach owning a fund from a company that you feel tried to cheat you. Scott Bordelon, CFP and president of Financial & Investment Management Advisors Inc., in Covington, La., says his company sold Janus midcap value fund for moral and financial reasons.

"We had to make a decision to sell even though we really didn't want to. Do you want to do business with an adviser, in this case, the fund family, that puts their interests above their investors'? What kind of message does it give to our clients if we stay in Janus?

"But I also realized there could be a major backlash and even the midcap value fund could be faced with massive distributions, an exodus. Do I want my investors to bear the tax and transaction costs?"

The mutual fund scandal shows how even careful investors can be victimized by unscrupulous members of the financial industry. Now we know that the lessons we learned about asset allocation and not chasing past performance aren't enough. But how are we supposed to know when the prospectus says one thing and employees are doing another?

"We never before saw salespeople violating a prospectus," says Kinnel. "The scandal highlighted that there can be firm-wide problems that put your assets at risk. At any big organization, there's the possibility of a few goofballs. There's never the guarantee that everyone will behave ethically. But there were some bad decisions made by top people. This isn't a few lackeys way off doing some dumb things."