Is Your Mutual Fund Clean?

On

a Saturday morning four weeks ago, New York State attorney general Eliot Spitzer walked onto a tennis court in Washington for a match with his niece and chanced upon Matthew Fink, president of the Investment Company Institute, the mutual fund industry's trade group. Howya doing? Spitzer asked. Fine, Fink answered. He then mentioned that his industry seemed to be under unusual scrutiny, adding, "At least you aren't giving us a hard time." Spitzer's response left Fink weak in the knees. "Just wait," he said with a smile.

Fink didn't have to wait long. On Sept. 3, the crusading A.G., fresh from lashing the brokerage industry into a $1.4 billion settlement over fraudulent stock research, revealed his latest target: the mutual fund business. This time Spitzer asserts that the industry we have trusted to put us on equal footing with the big hitters was favoring them at our expense — through short-term trading schemes that dilute the gains of long-term holders.

His investigation issued its first criminal charge last week and began to shift to a second set of mutual fund trades — those by Millennium Partners, a $4 billion hedge fund run by storied Wall Street investor Israel Englander. And Spitzer wasn't the only cop on the Wall Street beat. The NASD, a securities-industry regulator, had settled a separate case with Morgan Stanley, which it charged with offering brokers improper incentives to push in-house funds that might not be best for its clients.

The fallout from Spitzer's assault has been swift. Fund-research firm Morningstar — the 800-lb. gorilla of independent fund analysis — took the unprecedented step of warning investors to avoid the four fund families at the eye of Spitzer's storm — Strong, Bank of America's Nations Funds, Bank One's One Group, and most Janus offerings (except for its Mid Cap Value, Small Cap Value and Risk-Managed Stock funds, which are run by outside managers). "The firms put their own profitability ahead of shareholders'," says Kunal Kapoor, Morningstar's associate director of fund research. "Until we see changes, we don't think they deserve to be trusted with people's money." A riled-up Janus shot back that Morningstar was acting with "recklessness and irresponsibility." The company said it has pledged to cooperate with Spitzer and even put back money after it determines which funds were hurt and by how much.

The fund industry, its trust breached, is now making all the right noises. Fink called the alleged abuses "outrageous" and urged all his group's members to review their internal procedures. Spitzer's investigation is far from over, though, and it may touch broadly an industry entrusted with $7 trillion of our retirement and other savings — a gargantuan sum that politicians will be eager to make a show of protecting.

Spitzer's investigation, which like his stock-research probe has been based in large part on incriminating corporate e-mail, will almost certainly lead to additional inquiries about fund fees and the roles of fund directors. It may also lead to efforts to corral the largely unregulated and fast-growing hedge-fund world, which has $600 billion in assets. It's the hedge funds, investment vehicles available mainly to the wealthy, that sometimes roil markets with rapid trades of stocks, bonds and currencies and that appear to be the main clients that have traded mutual fund shares in a way that is harmful to most mutual fund investors. For years, Congress and the Securities and Exchange Commission (SEC) have talked about improving oversight of hedge funds and the industry in general. But not much was done — until Spitzer started paying attention. "It's been a wake-up call to Congress," says Burt Greenwald, a mutual fund — industry consultant.

At the heart of the Spitzer probe are two practices that, by some estimates, collectively bilk fund investors out of as much as $4 billion a year. One is late trading, which is illegal. Spitzer brought grand-larceny and securities-fraud charges against Theodore Sihpol III, a former broker at Bank of America, alleging that Sihpol helped Canary Partners, a hedge fund, place orders to buy and sell Nations Funds shares as late as 6:30 p.m. at the funds' 4 p.m. (closing) price. The scheme allowed Canary, which has settled its case with Spitzer for $40 million, to profit from intervening news. (Many big corporate announcements are made just after the close of the trading day.) Sihpol's attorney says his client had supervisor approval for his actions.

The second practice is market timing, with investors trading in and out of a fund on a daily basis. That practice is legal, but large fund companies generally discourage it. For buy-and-hold outfits such as Fidelity Investments and Vanguard Group, market timers drive up transaction costs, which are borne by all shareholders. Plus, the rapid movement of money makes a fund difficult to manage, possibly hurting long-term returns. In international funds, market timers may be able to take advantage of "stale" prices — trading a fund in the U.S. when the price may not yet reflect movement in foreign markets. From a legal standpoint, market timing is an issue only for funds that officially ban it but make allowances for hedge funds and others who pay them big fees. Market-timing violations are far more widespread than late trading. The cases against Janus, Strong and Bank One are limited to market timing, which academic studies show can raise costs as much as 2% of a fund's assets each year — a detriment to long-term holders.