Don't Let Your Mutual Fund Misuse Your Money

The Wall Street Journal recently ran a story describing a payout from the Reserve Primary fund. The Reserve fund, as you likely recall, is the money market fund that "broke the buck" last year, sending a shiver through Wall Street and Washington that ultimately resulted in the Treasury's now-defunct money market insurance program.

If you read the article closely, you'll see a passing reference to an often-overlooked characteristic of mutual funds that is extraordinarily distasteful.

First, a bit of background. The Reserve fund broke the buck because the fund's manager was caught holding large quantities of Lehman Brothers debt. When Lehman went bankrupt, they couldn't sell these toxic assets. That, combined with soaring redemptions and the lack of a fresh source of capital to meet those redemptions, led the fund to break the buck.

Obviously, the fact that the fund was holding so much Lehman Brothers debt in the late-summer of 2008 is a bit curious. After all, rumors of Lehman's impending demise had been swirling for months. But the fund's manager was attracted by the high yields he could earn on the Lehman debt. (And many of the fund's investors, it should be pointed out, were not completely innocent. Attracted by the higher yields supplied by such questionable investments, investors pumped money into the Reserve fund as fast as they could, making the fund one of the industry's largest in a span of months.)

Nonetheless, the Reserve fund is now being sued by investors who claim -- with obvious justification --that the manager was taking on far more risk than was prudent in a supposedly safe money market fund.

As you would expect, the fund's managers are mounting a defense, and generating big legal bills along the way. Who foots that bill? Here's a hint, from the second-to-last paragraph of the Wall Street Journal story:

Of the remaining $4.5 billion [assets that the fund has yet to distribute to shareholders], $3.5 billion will remain in the Primary fund to be used for costs and expenses, including legal and accounting fees, pending or threatened claims against it, its officers and trustees, and claims that could be made against its assets.
Yes, you read that right. The fund is using its investors' assets to pay the legal fees it incurs in defending itself in lawsuits brought by fund shareholders. It's what has come to be known as a "shoot the hostage" defense: sue us for mismanaging your money, and you'll only end up depleting the amount of money you recover, because you're paying our lawyers.

Pretty sweet deal from the manager's perspective; pretty lousy from the investor's. Yet it is a typical arrangement in the mutual fund industry, and most fund prospectuses contain language that permits them to do precisely what the Reserve Primary fund is doing.

The bottom line is that fund investors have little recourse in cases like this. Absent outright fraud, investors have a very slim chance of recouping any meaningful amount that they lost.

So what should you do? Ideally, it would be wonderful to see the SEC (or Congress) force mutual fund managers to fund their own defense against these lawsuits. These are enormously profitable enterprises we're talking about here, and perhaps such a traditional arrangement would cause their firms' risk management departments to look a bit more closely at the decisions their managers are making.

Absent that sea change, the onus is on you, the investor, and the message is one you're likely familiar with: Don't just jump in bed with the first fund you stumble across offering a sweet yield or spectacular short-term performance. Dig a bit deeper, and investigate the sources of that performance. And consider the history of the fund's sponsor. Do they have a history of run-ins with regulators? Of offering funds that follow a boom and bust cycle?

There's no way to guarantee that you'll avoid a fund that ends up being sued by its investors, but it's yet another reason to do your due diligence. After all, if things go awry, the assets used to defend the manager against shareholder lawsuits could be your own.