INVESTMENTS Mutual funds face potentially costly effects of pullouts

Watch investigations of funds but don't panic, advisers say.
NEW YORK (AP) -- As regulators continue to probe mutual-fund practices, many skittish investors have been opting to get out of funds accused of wrongdoing. Although advisers caution against panic selling, they say continued outflows could hurt those investors who stick around -- even if a fund is later vindicated.
In recent weeks, mutual funds managed by Putnam Investments and Strong Capital Management Inc. have seen outflows from investors' bailing out. Putnam last week said it had a $9 billion decline in assets, falling to $247 billion in part because of redemptions after pension funds in several states fired the fund company as their manager.
Although Putnam said the large redemptions have not interfered with its ability to run its funds effectively, investors might want to pay attention if large-scale selling continues or if the market were to decline significantly and reduce a fund's assets, financial planners say.
"We're not worried about the mutual-fund market in the long run," said Deena Katz, a certified financial planner in Coral Gables, Fla. "But on the other hand, the big danger is whether there will be a big run on these funds.
"That makes them more expensive, and share prices will go down, so that's the big exposure for people who are invested," she said.
Ripple effect
In particular, fund managers who encounter large outflows often must sell investments they might otherwise choose to hold, leading to larger capital-gains tax costs. Or they might hold an unnecessary amount of cash in anticipation of more redemptions.
A fund thus could lose out on returns if a fund manager is unable to be invested significantly in the stock market before the next big rally. It also means the manager might have less flexibility to stick with the fund's asset allocation.
Meanwhile, the higher turnover and selling creates higher transaction and expense costs, which are spread out across fewer people as investors sell.
"The reason why performance may go down if there are heavy redemptions has nothing to do with the ability of the portfolio manager," said George F. Leupold Jr., a certified financial planner in Cherry Hill, N.J. "So investors should closely monitor the situation."
Investors who participate in mutual funds through 401(k) retirement plans have to less to worry about, because taxes are deferred. In addition, given the three-year bear market, many fund managers likely have large capital losses built up that they could use to offset capital gains in 2003.
And investors who have money in fund families that have been implicated but not in the actual funds under investigation might want to see the cost impact. Often, the expenses are limited to the particular fund, although some companies might spread it across the entire fund family.
Keep watch
So what should investors do?
Advisers emphasize that there is no immediate need to bail because the rising stock market has helped buoy mutual-fund assets and given fund managers more flexibility. They also note that the industry as a whole appears to be reputable and should be particularly strong once the probes shake out.
But investors should monitor the investigations and consider changing funds if outflows continue to be high or the market begins to decline.
"If the market were suddenly to turn south and managers have to sell their stocks quickly, Putnam, for example, might end up taking a fire sale price for the stocks. That could impact the performance of the whole fund," said Laura Lutton, mutual-fund analyst at Morningstar Inc.
Other factors to consider might be whether an investor purchased class B shares of a mutual fund through a broker. B shares don't charge an initial brokerage fee but charge a back-end commission if shares are sold within six years; it might be costly to sell shares unnecessarily.
"I wouldn't get out of all mutual funds, just because some fund group might be hit down the road," Leupold added. "Over the long term, funds are the place to be instead of being an individual-stock picker because of the diversification and professional management.
"But if investors are nervous and having trouble sleeping at night, they might pull out and see what happens," he said.