Mutual Funds Rocked by Corporate Scandal

Although until recently, the trillion-dollar mutual fund industry had largely escaped the kind of scandal that plagued corporate America over the last three years, New York State Attorney General Elliot Spitzer recently exposed impropriety in even that industry. The Attorney General's findings in early September left the public's trust in mutual fund stability irrevocably tarnished.

Mutual funds are used by investors to pool their money in order to invest in stocks, bonds and other accounts. Many investments that would be out of reach for the average investor due to high buy-in costs are well within the reach of a mutual fund. Investors prefer mutual funds to diversify portfolios and thus avoid an abundance of eggs in one basket. Thus, believers in the stock market's potential -- whether generally or particular to a business sector -- need not rely on one particular stock's success to profit. Instead, they might invest in a mutual fund, which in turn invests in a large collection of stocks. These stocks might derive from one sector (bio-tech, cyclical stocks, health, etc.), or they might attend to market capitalization (small cap, mid-cap, etc.). "Mutual funds offer broad diversification, professional investment management, flexibility and liquidity, often at a very low cost," says Michelle Smith, managing director of the Mutual Fund Education Alliance. "Mutual funds make it possible for anyone to participate in the success of the financial markets."

Most consider mutual funds much safer investments than traditional stocks, for those precise reasons.

On September 3, Mr. Spitzer brought charges against four financial institutions with mutual fund offerings: Bank of America, Bank One Group, Janus Capital and Strong Capital. He would soon levy additional charges against such investment giants as Morgan Stanley, Charles Schwab, Prudential Wachovia, Alliance Capital and American Express, among others.

He charged that some larger investors gained an unfair advantage by trading in and out of their mutual funds in an illegal manner. The special treatment afforded to these privileged investors (usually managers of hedge funds, a type of investment partnership for high net-worth investors) allowed them to trade after standard (and legal) 4 p.m. cutoff point for mutual fund trading. This illegal behavior allowed selected investors to capitalize on late developing news stories that would otherwise affect the value of the fund's portfolio the next business day. Mr. Spitzer explained that they were "betting today on yesterday's horse races."

A second charge leveled against the mutual funds was participation in a scheme commonly called "market timing." Hedge funds often move millions of dollars in and out of mutual funds quickly, based on short-term market indicators. While this practice is not illegal, many mutual funds discouraged and even prohibited its practice due to the disruption it tended to cause the fund's other investors. Spitzer charged that some mutual funds placed restrictions on short-term trading for all investors and subsequently waived these restrictions for only their larger (and thus more profitable) customers. These actions sacrificed the interests of small investors in order to cater to the big-time players.

Skirting such rules can endanger the stability of the mutual fund as a whole. Say, for example, that a mutual fund holds $100 million in assets, and a large hedge fund owns a $50 million stake of these assets. If this hedge fund suddenly sells $25 million of its stake, the remaining $75 million (belonging to other investors) is jeopardized. By law, the mutual fund must transfer the cash from that sale within three business days. The fund must have the cash to meet that redemption, and its manager has two options. He might sell a large number of stocks or bonds to immediately raise the cash necessary to meet that redemption, but he will likely need to re-purchase them soon after. This could result in significant damage to the fund's overall value, due to the immediacy of the sale and subsequent buyback. The manager's second option is to pre-empt the problem by keeping a large amount of cash on hand in case a large holder suddenly pulls out. Such action often hurts the fund's overall future value, since a significant portion of the fund's resources remain parked in low-yield investments.

For the 95 million Americans who currently entrust their money to mutual funds, this spreading scandal raises grave concerns. Regulatory changes are likely to result in tighter restrictions for all investors involved in mutual fund trading. The good news for those vested in one of the tainted funds when illegal or improper trading took place is that monetary losses are likely insignificant.