Is Your Mutual Fund Clean?

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Sources familiar with Spitzer's investigation say the next company on the grill is likely to be the private Millennium hedge funds run by Englander. These funds racked up big gains in the recent bear market, according to Institutional Investor, rising 10%, 16% and 36% in the past three years — when the value of the average stock and stock mutual fund declined. Sources tell TIME that Spitzer is looking at possible late trades and market timing by Millennium, though it is not clear which mutual funds and which brokers Millennium was dealing with. Through a spokesman, Englander, who is prominent in New York City charity circles and owns several specialist firms on the floor of the American Stock Exchange, declined to comment.

Spitzer says the mutual fund industry got on his radar through its own hubris. He first took notice a year ago, when the SEC (then under embattled chairman Harvey Pitt) was pushing the industry to disclose how fund managers vote their shares when corporations elect directors and decide other issues, such as takeovers. The fund industry resisted, saying, in part, that such disclosure would be expensive. "That's malarkey — put it up on your website," Spitzer recalls telling them. "I thought these guys were completely arrogant." By resisting calls for disclosure, Spitzer adds, "it should have been apparent to them that it would raise questions to people like me." He was further piqued by what he felt was the abrasive tone of some fund executives at a panel discussion at Harvard Law School last June, when he concluded that "they just don't get it." Shortly after that, he got a critical tip — he would not elaborate — leading him to the questionable trading practices at Canary and the four mutual fund companies.

Many in the fund business say they are annoyed that Spitzer has characterized the abusive trading practices as widespread — without providing further evidence. Yet only a few, among them Vanguard, Fidelity and T. Rowe Price, have come out with strongly worded assurances to investors that they are doing everything possible to avoid the problems. "We didn't even wonder if someone was doing that here," says Jack Brennan, chairman and CEO of Vanguard. "We have a lot of defenses to avoid that possibility, but most importantly, it's the ethic of the firm." Spitzer defends his investigation and his decision to take it public, saying he cannot name other names until he has built a case. Moreover, he says, by spouting off early "we probably have stopped a lot of it."

Eradicating the abuses will be difficult. Fund companies have less control over the trading of their fund shares than one might imagine. Most fund shares are traded through third-party brokers who don't report activity to the fund companies until well after the close of trading — after they have tallied the full day's activity and netted out buys and sells. "The challenge," says Edward C. (Ned) Johnson III, chairman and CEO of Fidelity, "is to reduce the opportunity for wrongdoing." Johnson suggests two steps: first, assign fiduciary responsibility to any company that has any part in executing a mutual fund trade, so if shareholders' best interests are not served, penalties will follow; second, create a central clearinghouse for all fund orders, thus ensuring that trades are executed at the correct price.

What should investors do in the meantime? "Stay the course," advises Spitzer, whose own family fortune rests in real estate. "The marginal cost to any one shareholder is slim." In the end, says Morningstar's Kapoor, you should invest in a fund company you trust. Find one, he says, that emphasizes "stewardship over salesmanship," that puts long-term shareholders first by keeping expenses low, that closes small-cap funds once they get large and that refuses to roll out gimmicky funds in hot sectors.

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