Mutual funds tarnished

By Rachel Beck
Associated Press

NEW YORK — Maybe it was too good to be true. The mutual funds were supposed to be the good guys of the investment world, immune from the scandals that rocked Wall Street and corporate America.

Alas, reputations can only hide wrongdoing, not prevent it.

It now appears that mutual fund companies participated in their own share of dirty dealings, which particularly hurt ordinary investors.

Sure, funds marketed themselves as having their interests aligned with their shareholders. But as it turns out, some weren't treating all investors the same when they gave significant trading privileges to certain shareholders who were then able to line their pockets with earnings at the expense of others.

"Mutual fund, as the name suggests, is supposed to mean that all investors are in there equally together, and that apparently wasn't always true," said Russ Kinnel, director of fund analysis at fund-tracker Morningstar.

Not every fund company is embroiled in this mess, but the investigation seems to be growing every week, and many of the best-known firms — including Janus and Bank of America — are now connected to it in some way or another.

Funds, of course, never could guarantee positive returns, but investors thought their diverse holdings were a safer bet at a time when corporate executives had been caught manipulating earnings, and analysts were discovered having issued overly bullish research so that their firms could win lucrative investment banking business.

Fund managers, it was long thought, want to do well with their stock picking to increase the value of their portfolios, a boon not just to investors' pocketbooks but also to the funds' own fee income.

But it seems that some may have let their own interests supersede those of ordinary investors.

That's the gist of the case now being pursued by state and federal securities regulators, who are investigating whether mutual funds gave special trading privileges to hedge funds and other large investors at the expense of other shareholders. In some cases, those privileges were permitted in return for making substantial investments in the funds.

Two issues are under review. One is called "market timing," which allows savvy traders to take advantage of the time differences between the closing of U.S. markets and those overseas. It can also involve short-term, "in and out" trading.

While market timing is largely legal, many funds prohibit the practice. For that reason, the Securities and Exchange Commission considers violations of those policies fraud against other shareholders.

The other is called "late trading," which involves purchasing mutual fund shares at the 4 p.m. price well after the market closes — a practice which New York Attorney General Eliot Spitzer has deemed equivalent to "betting on a horse race after the horses have crossed the finish line." Late trading is illegal.

Such arrangements allow the investor to cash in on after-hours news ahead of other investors, who at that hour would be forced to chance buying at the next day's closing price. Mutual funds are priced just once a day.

That exploitation of changes in prices can hurt other fund shareholders, especially those holding on for the long term, by diluting the value of their shares.

So far, more than a dozen mutual funds are under investigation, and a handful of employees have pleaded guilty, been charged or have settled with regulators.

Bank of America said earlier this month that it would set aside $100 million to pay for legal fees and other scandal-related expenses, including a restitution fund for investors. Janus said it will pay investors about $1 million in management fees that it earned on the money from the often-trading hedge funds.

Still, investors aren't taking this mess lightly. With memories of other scandals fresh in their minds, they aren't taking chances by keeping their money in some of these funds.

In September alone, about $7.9 billion was withdrawn from funds run by Janus, Bank of America, Banc One and Strong Capital Management, the companies named in Spitzer's investigation, according to mutual-fund tracker Lipper.

"Trust is built slowly and can be dashed in an instant," Lipper said in its latest report on fund flows.

The good news is that it may be tough for such trouble to happen again. Now that the scandal has made headlines, fund companies are implementing better controls, and the SEC is considering new rules.

Whether that can do anything to woo investors back to certain funds remains to be seen.