INVESTING: Getting behind the scenes of the mutual fund market

For many retail investors, mutual funds have become a necessary evil. But the last five years of crazy market performance has exposed a lot of average talent among fund managers, along with a great reduction in enthusiasm on the part of investors.

People seem to stick with mutual funds because they do not know alternatives exist. If they only knew what went on behind the scenes.

For instance, the buyer of a no-load mutual fund may think because he isn’t paying an upfront fee, he’s getting something for nothing. But the fund charges an annual expense ratio on the average of 1.25 percent a year, which is deducted at the end of every trading day. So, as long as you have money in that fund, the managers are getting paid.

The discount broker Schwab invented a useful tool called the mutual fund supermarket. This tool consolidated thousands of funds and put information and data about these funds right at investors fingertips. These funds are typically no-load and Schwab does not charge a commission to trade them.

So, why does Schwab do this? It goes way beyond just another level of customer service. Schwab gets a fee from every fund one of its clients buys. Usually, it receives 30-40 basis points from the fund. I am not against people getting paid for a good idea; it’s just that a vast majority of Schwab clients have no idea this is going on.

Another new negative for the mutual fund world has emerged from the recent fund-timing scandals New York Attorney General Eliot Spitzer attacked. Unfortunately for retail investors, the slang “mutual fund timing” was probably the wrong term to associate with this scandal.

Fund timing invokes ideas that big investors were using mutual funds to practice market timing. That’s not what happened. Large institutions were allegedly buying specific mutual funds after the market closed and the fund companies were giving them that day’s closing price.

Here is an example: A particular tech fund has a large holding in Intel Corp. Intel posts some great news at 4:15 p.m., just after the market closes. Intel is sure to gap up the next morning. The fund company allows the institution to buy shares in the fund at 4:30 at today’s price, before tomorrow’s gap-up, which creates an instant profit.

As is typical with government intervention, the law of unintended consequences is falling on the average American. For instance, if you buy a Fidelity fund in your 401(k) account, you will get a notice that Fidelity will penalize you 1 percent or more if you sell that fund in 60 days or less. Remember, Fidelity is taking fees out of your account every day you own the fund. Spitzer’s rampage has given Fidelity an opportunity to keep you in the fund longer, which is going to lead to far more profits than the scandal activities ever could. Pretty sweet.