Beware nasty side effects of 'cure' for mutual funds

Sometimes, the cure is worse than the ailment.

Generally, you can't tell until the symptoms are gone and you've returned to normal. That applies to the mutual-fund world every bit as much as health care.

So when the Securities and Exchange Commission (SEC) unveiled its proposed cure for the activities that have created the current wave of scandals sweeping the fund industry, the question was whether it was delivering bad medicine.

The commission voted unanimously to propose a rule that targets late trading in mutual funds by imposing a strict cutoff on transactions at 4 p.m. Eastern time.

If a fund or its transfer agent receives a trade order after that, according to the proposal, the trade is processed at the next day's closing price.

The SEC also adopted a rule that would force mutual funds and their advisers to create a range of compliance policies and to appoint a chief compliance officer who would report directly to a fund's directors.

The final big idea to come from the commission was new rules requiring funds to provide a better disclosure of how they value securities, to disclose the rules they use in giving out information about the securities in the fund and what their policies are concerning frequent trading.

The proposals are out for a 45-day comment period, and many people close to the situation hint nothing would not have passed unanimously if the commission had been writing final rules, rather than releasing a trial balloon.

With the exception of the disclosure proposal - which no one seems to have significant objections to - there are some serious concerns about the SEC's suggestions.

The 4 p.m. Eastern cutoff has a lot of critics, and for good reason. Providers of employee benefits note that virtually all trades into 401(k) and other retirement plans would be processed a day after the order is entered, due in large part to the intermediaries involved and the way in which such trades are aggregated to make the money movements efficient and cost-effective.

The new rule requires that funds - and not those intermediaries - get the order by 4 p.m., meaning any trade made through a broker or in a retirement plan would almost certainly have to be placed by 2 p.m. to be certain of capturing the current day's price.

Obviously, that's a big challenge for West Coast investors, who might miss the boat even if they place an order on their lunch break.

A reform bill overwhelmingly approved by the House calls for a "soft" deadline, one that would allow for orders to be processed after 4 p.m. , provided the funds have a paper trail to review, so that any potential trading abuses could easily be detected.

The trading delay is the bitter pill investors might have to swallow in the name of reform. Opponents are outraged at the prospect, spouting rhetoric about how investors will pay higher prices because of the transaction delay.

It's a valid concern, but it may not be as big as critics contend. Vanguard founder Jack Bogle notes that if a trade is delayed by a day, history suggests it will be completed at a higher price about 51 percent of the time, and prices will move down about 49 percent of the time.

What the SEC is implying with the rules proposal is that funds are for long-term investors, and big amounts of time diminish the potential impact of having a trade processed on a Tuesday instead of a Monday.

No one gets to retirement age and says, "I have to keep working because, over the years, bits of my money lost out on one extra day in the market."

Heck, many investors in no-load funds still make deposits through the mail, a de facto statement that putting money in the fund is more important than getting "today's price."

The compliance issues have an unspoken but sticky component, too. If fund firms need additional compliance officers, shareholders will pay for them. Say hello to higher costs, just as regulators are shining a spotlight on fees.

It's hard to get firms to reduce costs when you are giving them additional duties, and investors will benefit more from cost-cutting measures than from stepped-up compliance. As much as the fund scandal has made headlines, it is a small number of funds out of a huge population.

Said fund-industry consultant Geoff Bobroff, of East Greenwich , R.I. : "Every potential solution has consequences and costs. The people in Washington are focused on stopping the problems, but they have to be careful because the disease isn't killing anyone, but the cure just might. The problem is that we won't know it for certain until after the rules are in place."