Be Sure to Understand Deal Before Investing

Ask questions. Don’t be embarrassed. Think for yourself. Caveat emptor.

Marianne K. Smythe, director of the Securities and Exchange Commission division that regulates mutual funds, sounds a theme of caution, awareness and plain common sense for investors.

It’s not that she thinks that the fund industry is crooked--far from it. But Smythe, a former University of North Carolina law professor who has worked at the SEC on and off since 1976, does see room for improvement. She urges shareholders to take the time to investigate mutual funds and the people behind them, to help protect themselves and make the playing field more level.

A typical problem occurs when a load fund company develops a product and encourages brokers to push it, even when the fund might not be in the best interest of certain investors. “The sales force works on a commission basis, and it will respond to that urging,” Smythe says.

She pointed out the proliferation of junk bond portfolios--euphemistically labeled high-yield funds--during the 1980s. “I wonder how many of the people who purchased (these investments) understood that high yield really meant high risk as well as the potential for high yields.”

It comes down to a question of suitability, she says. Brokers must be careful not to peddle investments that aren’t appropriate for certain individuals, given their income, risk tolerance, sophistication, tax considerations and other factors.

“I wish my fellow citizens would ask more questions,” Smythe said. “If you don’t understand something, ask. Don’t be embarrassed. And if the person can’t explain it to you, it’s because he doesn’t understand it or doesn’t want you to.”

Nor does she consider it rude to ask what the broker is getting out of the deal. “Salesmen have a right to earn a commission; everybody understands that,” she says. “You need to know whether the product in which the salesperson gets the higher commission is better for you or him.”

Although she cautions that the SEC isn’t always in a position to resolve disputes, letters of complaint from investors help it identify problem areas. “This is certainly one way the agency becomes alert to what’s going on out there,” says Smythe, noting that the laws the SEC administers are designed to protect investors, not companies.

Smythe emphasizes that people must take responsibility for their own financial decisions, provided that they’ve been told the pertinent facts. In other words, anyone has the right to put money into speculative investments, as long as the risks and costs are disclosed.

Mutual funds, of course, are sold with a prospectus, a legal document that spells out various risks and fees. The SEC in recent years has prodded funds to develop prospectuses that are more streamlined and easier to use. Starting in 1988, funds have had to disclose their operating expenses, sales loads (if any) and other charges in a standardized fee table.

Compared to, say, a limited partnership roll-up prospectus that might run several hundred pages, the typical mutual fund prospectus, at perhaps 16 pages, is an easier document to deal with. Even so, investors need to show some willingness to get familiar with it.

“The problem with the (mutual fund) prospectus isn’t that it’s too long, but that people don’t like to read one, period,” Smythe said. “Maybe it would help if we could get them to put these things on a video- or audiocassette and you could listen as you drove in your car.”

A couple of other documents are also worth looking at: the Statement of Additional Information (often called the second part of the prospectus) and the proxy report. That’s because they provide information on the independent members of a fund’s board, the main shareholder reps. You should feel comfortable that these board members have been selected because of their independence and ability to understand what’s going on, Smythe says.

In this era of financial-industry scandal, Smythe points out that the Investment Company Act of 1940, the basic legislation that regulates mutual funds, contains a “bad boy” provision. It prohibits any person who has been convicted of a financial crime within the past 10 years, or enjoined for violating a securities or commodity futures law, from being associated with a mutual fund.

After 51 years, the SEC is reviewing the act and some changes will almost certainly be made. Some funds might be given permission to redeem shares less often than once a day; this would presumably help those portfolios that hold less liquid securities. There’s also talk of removing certain restrictions on fund advertising and marketing, such as allowing people to fill in a coupon and send in money, without first waiting for the prospectus.

However, the basic checks and balances, which act to discourage foul play, will remain unchanged, Smythe predicts. Her reasoning: The legislation has worked too well to tinker with, in that it has kept the burgeoning fund industry, now with more than $1 trillion in assets, free of major scandal.

“You only need to contrast it with the problems in the banking and savings and loan industry where, for the better part of three or four years, Congress has been embroiled in addressing serious problems in an atmosphere of terrible economic consequence,” Smythe says. If you feel you’ve been misled or otherwise wronged by a fund company or salesperson, Smythe would like to hear from you. Write to: Securities and Exchange Commission, Room 1065, Stop 10-6, 450 5th St., N.W., Washington, D.C. 20549.