How the Fund Scam Works

So far mutual fund companies have slipped through the regulatory crackdown on Wall Street unscathed. That is about to change. Dramatically.

New York Attorney General Eliot Spitzer said Wednesday that mutual fund companies played a key role in -- and profited from -- a swindle that enabled hedge funds to fleece their own unsuspecting shareholders. The scheme worked because funds allowed select investors to exploit flaws in the fund structure.

Mutual funds are the most popular investment vehicles in the world because they offer diversification, professional management, ease of investing and reasonable costs. But funds have a tragic flaw. A loophole so big you can drive a truck through it -- if fund companies let you.

Unlike closed-end funds, hedge funds and other investment pools, open-ended funds allow investors to buy and sell shares each day at the fund's net asset value, or NAV. The NAV is the current value of all the fund investments divided by the total shares. The benefit from this for shareholders also has a major flaw. When investors move money in and out, they leave a wake of trading costs and tax inefficiencies that must be shared by other investors.

Worse, daily fund pricing is an inexact science, the negative effects of which can be magnified by fund flows. Pricing is particularly troublesome with less liquid investments like micro-cap stocks, municipal and junk bonds, and with foreign securities that trade on markets that close hours before our market opens.

If a fund NAV is off, traders can hop in and out to make free money -- effectively stealing returns from other investors. Funds usually impose Band-Aids to fix this underlying problem with the mutual fund structure. These repairs include short-term redemption fees (unlike loads, these fees get reimbursed to the fund to cover costs) and kicking out active traders.