For mutual-fund clients, a question of confidence

As allegations of fraud and impropriety rock the normally placid world of mutual funds, Wall Street is tensely waiting to see if investors in the $7 trillion industry will ride it out or punish offenders by yanking out their money.

A few institutional investors have already run for cover after last week's indictments for fraud aimed at the nation's fifth-largest fund company, Putnam Investments, and two of its fund managers.

By themselves, the charges by federal and Massachusetts regulators probably won't cause many small investors to do the same, investing analysts say. But much depends on how far the scandal reaches.

In all, about a dozen firms have so far come under fire for illegal or officially discouraged practices, or both. Charges often involve rapid forms of trading by fund employees in their own funds - in ways that position them to gain where ordinary shareholders cannot.

A much broader swath of the industry may ultimately feel the heat.

"I expect there to be more revelations going forward, and probably half of the mutual-fund complex to be implicated in one way or another," says Mercer Bullard, a University of Mississippi law professor and former SEC attorney who runs Fund Democracy, a watchdog group. "This scandal reflects a systemic failure of compliance in the mutual-fund industry."

Regulators are sure to finally tighten their grip, many experts agree.

In the Putnam case, some institutional investors didn't wait for rulings. Thursday the Massachusetts pension board voted to pull $1.7 billion from state retirement accounts run by Putnam. On Friday, Rhode Island pulled its state pension funds as well. Private firms may be reevaluating their retirement-account offerings, in part to protect themselves from possible liability, Mr. Bullard says.

As 401(k) planners meet in the coming months, another wave of institutional losses could hit the funds involved, says Don Cassidy, senior research analyst at fund-watcher Lipper Inc., in Denver. News of their pullouts could further spook small investors, among whom discontent is already deepening.

In a survey, slightly more than half of those polled said their opinion of mutual funds as an investment was "much less favorable" in light of the unfolding scandal. BusinessWeek conducted that poll in September - the month in which New York's attorney general, Eliot Spitzer, leveled allegations at several big fund companies, including Janus. About 41 percent said they would be "very likely" to consider selling shares in funds that were implicated.

The gap between saying and doing, however, can be significant. When fund firms Navellier and Yacktman fought publicly with their independent directors over proxy powers in the late 1990s, Mr. Bullard says, "a huge percentage of the funds' shareholders ran for the exits."

But a backlash against the mutual-fund industry at large seems not to be forming now. Figures released Friday by the Investment Company Institute, the fund industry's trade group, show September stock-fund inflows of $17.3 billion. That's "in line with past shareholder behavior," according to the ICI.

"The public is relatively apathetic," says Paul Farrell, a financial journalist and author of the forthcoming book "The Lazy Person's Guide to Investing." "The fund industry has been able to operate behind a veil of secrecy for such a long time that you really don't know how many bad things may be behind that veil."

Behind that veil, Mr. Farrell and others say, is a competitive drive for big personal gains fueled by the rise of an anything-goes culture within the fund industry.

"I'm concerned that the fund industry will continue pretty much operating - after the smoke clears on these two issues - in a vacuum that will push aside other issues," he says. Those include inflated expenses and fees and salary increases for managers, even in steep market declines.

But Lipper's Mr. Cassidy believes the scandals will serve as a shock to the system. "The good news is, unless there's a fund between Jupiter and Saturn" that hasn't heard the news, the illegal practices that probably cost small investors billions of dollars a year have ceased, he says.

Investors should see some recompense. The fund industry will want to settle up and get this crisis behind it in the next six months to a year, Cassidy adds.

Others maintain that a light may finally go on for investors. The industry is not devoid of ethics, experts insist. Socially responsible funds are widely credited with helping push the Securities and Exchange Commission to mandate disclosure on proxy voting for all funds earlier this year.

Investor awareness of such usually quiet developments could soon rise.

"What investors feel is that they used to be able to look up to experts, and put their faith in the experts," says Richard Geist, president of the Institute of Psychology and Investing in Newton, Mass.

Now, he says, investors will educate themselves about the market and its players. "You're going to see a massive shift in how people invest," says Mr. Geist. "People are going to ask a lot more questions."