Ask the Expert: What Should I Do With My Fund?

Editor's note: Got a question you'd like to ask about sectors, companies and issues affecting the markets? Email us at [e-mail] and one of our reporters will track down an expert. In today's "Ask the Expert," personal finance reporter Bev Goodman tackles what questions mutual fund investors should be asking in light of the mutual fund scandal.

You've heard the news. Now, what should you do to protect yourself?

New York State Attorney General Eliot Spitzer said last week that he's launching an investigation of illegal mutual fund practices and has reached a $40 million settlement with hedge fund Canary Capital Partners and its managing principal, Edward Stern.

Although Spitzer says that "the full extent of this complicated fraud is not yet known," the upshot is that Canary engaged in illegal trading practices with four major mutual funds -- Bank of America's(BAC) Nations funds, Bank One's(ONE) BancOne funds, Janus(JNS) and Strong Financial.

How can investors protect themselves from such practices? Unfortunately, unless you have the resources of Spitzer, there's no definitive way to tell if your fund is up to such shenanigans, but experts advise that investors keep an eye on two things in particular -- how fund shares are valued and trading costs.

The mutual funds are said to have allowed Canary to boost the hedge fund's returns by engaging in a pattern of late trading and market timing in the mutual fund shares. Fund shares are valued just once a day, at the market's 4 p.m. close. Late trading -- an illegal practice -- enables a trader to purchase shares in a mutual fund after the close of trading, but at their 4 p.m. price. That allows the trader to take advantage of after-market price swings. (Say a company announces some good news after the market close. A "late trader" would purchase shares in a fund likely to benefit from that good news at the market's open.)

Market timing, while technically legal, often violates a fund's stated policy that's registered with the Securities and Exchange Commission. Essentially an arbitrage strategy, this practice allows traders to take advantage of price differences that occur as a result of the time differences between the closing of U.S. markets and foreign exchanges. Some firms, such as Vanguard and Fidelity, aggressively prohibit such practices. But others are lured by the additional fees these deals bring in.

So here's what you can watch out for: Redemption fees are one sign that a fund discourages this type of behavior. Redemption fees are not back-end loads, which are simply fees paid to the broker after the sale of a fund. Rather, redemption fees get paid back into the fund itself. "If a fund has a redemption fee, they clearly recognize the potential problems," says John McGowan, chief operating officer of ReFlow, a firm that assists in minimizing the costs involved in fund flow management. Then again, a fund can waive those fees to maintain a lucrative relationship with a hedge fund investor.