Much publicized government investigations into mutual-fund practices have been initiated and a wave of shareholder-initiated lawsuits is sure to follow. The allegations are troubling, as the chicanery in question would benefit institutional short-term traders at the expense of long-term individual investors. We are confident that the funds we recommend are not especially vulnerable to these risks.

There are two practices in question. In one instance, it is alleged that an institutional buyer was allowed to engage in after-hours trading of fund shares. This is clearly illegal. Open-end mutual funds are priced at net-asset value (NAV) at the close of the market, 4:00 PM Eastern time, so a buyer could potentially purchase fund shares after the close at NAV, but also after learning of favorable after-hours news that would clearly have a positive impact the NAV the next day. Another practice, though not illegal, takes advantage of NAVs and time zones. An investor can purchase shares of an international fund shortly before the U.S. close, but at an NAV that reflects the close of Asian markets many hours earlier. If trends in the U.S. market during the day had given a clear indication of the direction of the Asian market upon reopening the next day, the trader could benefit.

Both practices benefit short-term “in-and-out” traders at the expense of long-term “buy-and-hold” investors, because the short-term investor can get in and out before his cash was even put to work in the fund’s underlying securities. Thus the fund’s NAV might increase, but by something less than the increase that would have resulted had the cash been fully invested. The short-term buyer can sell the next day at the modestly higher NAV, but the long-term investor would suffer to the extent that the NAV was diluted.

We are confident that the open-end mutual funds we recommend from Vanguard and Dimensional Fund Advisors are much less susceptible to these risks than are actively managed funds. Index funds are fairly transparent with regard to deviations between the performance of the fund and the index they seek to replicate, so any trading practices such as those described would be detectable. In addition, Vanguard has stringent trading rules including redemption fees, limited exchange privileges, and early trading deadlines for international funds. Dimensional also has rigid trading deadlines, and it virtually eliminates short-term trading by working only through institutions or investment advisors. By virtue of this “screen” the firm has in the past refused to accept funds from investors if the firm believed that the potential investors intended to employ the funds for short-term or speculative purposes.

These allegations have tarnished the mutual-fund industry’s image. We believe that now the distinction between actively managed funds and passively managed funds is more warranted than ever. It is equally clear that a firm’s reputation is important, and that investors should thoroughly investigate the trading practices of any fund before investing.

Also in This Issue:

Defined-Contribution Retirement Plans: Seize the Opportunity
AIS 401(k) Services
A Reader Inquires
Small-Cap Stocks: An Update
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield