Mutual fund investments drop by half as trading scandal widens

NEW YORK — As more financial firms are implicated in shady mutual fund trading, many investors are starting to worry about how extensive the abuses are. While they have no reason to panic, investors shouldn’t be surprised if they see an industry shakeout with more revelations of wrongdoing.

In the last few weeks, Merrill Lynch &Co., Alliance Capital Management Holding LP, Prudential Securities and Fred Alger Management have suspended or fired nearly two dozen employees believed to have engaged in illegal trading.

That comes after New York Attorney General Eliot Spitzer on Sept. 3 accused hedge fund Canary Capital Partners LLC of illegal trading involving Bank of America, Janus, Bank One Corp. and Strong Financial Corp. funds.

"There seems to be a lot more coming to the surface as a result of Spitzer’s initial investigation," said Phil Edwards, managing director of funds research at Standard &Poor’s. "(The funds) have enough respect for Mr. Spitzer to uncover the dirt themselves rather than let him, so you have more people coming forth."

The charges focus on late trading, in which investors are improperly allowed to trade after the close of markets at preclosing values, and market-timing, or short-term "in and out" deals, a practice that is illegal to the extent fund firms discourage it in their prospectuses.

Spitzer has said late trading and market-timing are widespread and could be unfairly costing everyday investors billions of dollars.

Investors appear to be taking notice.

The average weekly inflow into stock mutual funds dropped by half from $4.9 billion at the end of August to $2.2 billion at the end of September, according to AMG Data Services. That sharp drop-off can’t readily be explained without taking into account investor concerns about the mutual fund probe, said AMG Data president Robert Adler.

"The charges are a serious matter," said Brian Portnoy, mutual fund analyst at Morningstar Inc. "What’s being brought to light is a series of situations where regular long-term investors are being shafted or being given secondary priority to a fund companies’ profitability."

Still, analysts say it might be premature to draw comparisons with Spitzer’s last investigation. That probe, which alleged widespread conflicts of interest among Wall Street analysts, led to a $1.4 billion settlement with major investment banks.

The analysts note the financial damage in the mutual fund probe doesn’t appear to be as great. Instead, what appears to be more at stake is the fund industry’s stellar reputation as a trustworthy safe-haven for ordinary investors.

"It’s not an Enron or WorldCom situation where investors lost all of their money," Portnoy said. "The major story for the scandal is one of ethical missteps and whether fund companies are prepared to treat shareholders the way they deserve to be treated."

The industry already has started scrambling to restore investor confidence as the probe continues by Spitzer’s office and the Securities and Exchange Commission. Several fund firms, including Strong Capital Management, have hired outside auditors to examine allegations of wrongdoing.

Bank of America on Tuesday established a restitution fund for shareholders who lost money after one of its former brokers was charged with larceny and securities law violations.

And the Investment Company Institute, the trade group representing the mutual fund industry, said it has created two task forces to identify possible regulations or new practices to combat late trading and market-timing.

In the meantime, advisers are urging investors to remain calm until more details emerge from the investigation.

"It’s a little too early to make any major moves, because there’s just not enough known," Edwards said. "People should hold steady until they have the full facts at their fingertips."

Harry Winn, a mutual fund investor in Wilmington, Del., says he’s doing just that. He’s scanning the daily news but is staying put because his primary fund firms, Vanguard Group and T. Rowe Price, haven’t been named in any investigations.

"It concerns me that funds which are presumably looking after your interests are doing special favors with people (in hedge funds) with a lot of money," Winn said.

"It creates a bad image for the mutual fund industry," he said. "Hopefully some good will come out of it."