Despite late-trading scandal, don't give up on funds

MUTUAL FUNDS ARE AMERICANS' most trusted financial instrument. Roughly half of all households invest in them - to the tune of some $7 trillion.

No other financial vehicle even comes close.

So it came as a bolt from the blue early last month when New York Attorney General Eliot Spitzer announced his office had evidence of widespread illegal trading schemes "that potentially cost mutual-fund shareholders billions of dollars annually."

Should mutual-fund investors pull out and look for other places to put their money?

The short answer is no. Mutual-fund managers have a relatively clean record compared with brokers, investment bankers, or even insurance firms. But the spreading scandal should serve as a goad to mutual-fund firms to become even more vigilant.

Sadly, investors have become somewhat inured to corporate misbehavior. Trials of two high-profile executives, Frank Quattrone, a former investment banker of Credit Suisse First Boston, and Tyco International's former chief executive, L. Dennis Kozlowski, began in Manhattan last week. That's only the latest news on a string of misdeeds at the highest levels of business.

Fortunately, mutual-fund scandals are rare. Fund managers almost never get charged with cooking the books or with embezzlement, points out Tamar Frankel, a Boston University Law School expert. And they are sensitive to investors. They know their customers can quickly turn in their shares for cash if disenchanted. Should enough do so, managers get a pay cut or go out of business.

Mutual-fund managers do get criticized, or worse, for the fees and expenses charged their investors, or for advertising that exaggerates performance. "But I don't see an Enron," says Professor Frankel.

Mr. Spitzer's charges are, nonetheless, serious. "The mutual-fund industry operates on a double standard," the attorney general stated. "Certain companies and individuals have been given the opportunity to manipulate the system. They make illegal after-hours trades and improperly exploit market swings in ways that harm ordinary long-term investors."

He announced Sept. 3 a $40 million settlement agreement with Canary Capital Partners - a multimillion-dollar hedge fund, two Canary-related entities, and Edward Stern, the managing principal of these entities. Canary Capital, which admitted no wrongdoing, was charged with obtaining special trading opportunities with leading mutual fund companies, including Bank of America's Nations Funds, Banc One, Janus, and Strong.

Janus last week indicated it has ended relationships with 12 different clients, which allowed them to conduct rapid-fire trading. Not all did, though.

Spitzer's office says investigations are "ongoing." The SEC says it has sent "detailed information requests" to 80 of the nation's largest mutual-fund complexes, to prime brokerage firms, transfer agents, and large broker-dealers. So possibly more funds will face charges of "late trading" and "market timing."

"Late trading" involves the purchase of mutual-fund shares at the 4 p.m. closing price after the market has closed. Normally, transactions received after 4 p.m. are priced at the next trading day's 4 p.m. closing price. But the kind of "late trading" alleged by Spitzer allows a few favored investors to take advantage of events after the market close and still pay that day's 4 p.m. price. Spitzer likens it to allowing betting on a horse race after the horses have crossed the finish line.

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