Mutual Pain? Depends on Where Insider-Trading Probe Goes

In the space of about a decade, retail investors have soldiered through stock market collapses tied to a dotcom bubble, a housing bubble, and a ‘flash-crash.’ Throw in myriad brushfire scandals along the way and the average investor’s faith in equity markets has most certainly been tested.

It seems that faith is about to be tested again.

The latest major concern is whether, should the $10 trillion mutual fund industry be implicated in a growing insider trading scandal sweeping Wall Street, the millions of individual investors whose access to capital markets happens primarily via mutual funds may finally throw in the towel and pull their money out once and for all.

Last week news broke that at least two large mutual fund companies – Janus Capital Group (NYSE:JNS) and Wellington Management – are somehow tied to a sweeping three-year-old federal investigation into alleged insider trading.

Investigators are reportedly probing whether inside information was passed along illegally by employees of so-called “expert networks” from publicly traded companies to traders at hedge funds, and possibly mutual funds.

One arrest has been made in the case: Don Chu, 56, an executive at “expert networking firm” Primary Global Research, was arrested last week at his New Jersey home on conspiracy charges. He is accused of arranging for hedge funds to get insider tips on big technology companies including Atheros Communications (NASDAQ:ATHR), Broadcom Corp. (NASDAQ:BRCM) and Sierra Wireless (NASDAQ:SWIR) in 2008 and 2009.

Earlier last week the FBI raided three hedge funds seeking information.

Unfortunately for retail investors, the most chilling aspects of the investigation are also those for which there is the least amount of information. Namely, whether federal investigators believe big U.S. mutual-fund companies were paying for inside information from shady middlemen.

The FBI isn’t saying, declining to reveal specifics of the investigation. An FBI spokesman declined to comment for this story.

Meanwhile, on Thursday, Janus released a statement saying in no uncertain terms it is not a target of the investigation. “Janus has not been accused of any wrongdoing and the government confirmed that Janus is not a target of its investigation into potential insider trading,” the statement read.

Wellington has confirmed that it was contacted for information by federal investigators, but has otherwise remained silent. A spokesman didn’t immediately return a call seeking comment.  

If a worst-case scenario emerges in which mutual fund managers are implicated in an insider trading scandal, it could have a devastating impact on the industry.

“The problem that the industry faces, as well as the broader marketplace, is if investors conclude that investing isn’t a fair game. If we fail to attract the retail investor, whether that be in mutual funds or in general, we all lose,” said Geoff Bobroff, president of Bobroff Consulting, an East Greenwich, R.I., firm that works with asset managers.

But Bobroff also offered hope for a best-case scenario.

“The most important question is whether portfolio managers are ultimately drawn into the mix and some action brought against them. So far that hasn’t happened. The firms, at least, are not the target, and at the end of the day it may have minimal impact on the industry,” he said.

Many mutual fund investors and advisors believe the scandal points to the need for retail investors to stop trying to compete with Wall Street professionals, who follow every move of the markets and dart in and out accordingly, and instead adopt a traditional long-term approach.

The consensus on Bogleheads.org, a Web site named for John Bogle, the co-founder of Vanguard who has long advocated a long-term investment strategy, is that the insider trading scandal offers additional proof that long-term, “passive investing” is the safest bet for retail investors.

“Passive investing” is done primarily through index funds, which track either the whole stock market or smaller chunks of it, such as the technology or health-care sectors. The largest such fund is Vanguard’s Index 500 fund, which tracks the performance of all 500 stocks in the S&P 500 index.

These funds don’t employ active stock managers, so investors save on fees related to managers’ salaries, and investors can only be peripherally -- and minimally -- affected by an insider trading scandal.

Personal finance expert Jane Bryant Quinn explained the sentiment in a column posted on Bogleheads.org: “Once you’ve switched to an indexing strategy, insider trading can’t be a risk to your personal holdings. The mix of gains and losses in your index fund will reflect any trades that the big boys make on the secret information they’ve paid a bundle for. Another bonus is that  you’ll no longer have to look for a broker or money manager to trust. 'Trust' becomes moot when you invest in the market as a whole,” she wrote.

Bobroff agrees.

“The real issue that we’re living with today is that this has become a trader’s market not an investor’s market. We don’t have anyone talking about long-term investing anymore. It has led to a broad perception of the markets being conducted like a casino and scandals like this just accentuate it all,” he said.

Bobroff said it’s too early to say how the mutual fund industry’s connection – if there is one – to the insider trading scandal might play out. But if it persuades investors to take a longer view of their investment strategies, than all is not lost, he said.