Dissecting the Fund Industry's Big Problem

Here's a guide to what went wrong and what investors can expect in the future.
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The $7 trillion mutual fund industry is embroiled in its biggest scandal ever -- and there are plenty of questions that remain unanswered.

One problem is that a large number of the individual investors who were the victims of illegal trading in mutual funds don't understand many of the questions. Indeed, because some of the illegal behavior was "under the radar," plenty of investors aren't aware they are victims yet.

Unfortunately for investors and for the embattled fund industry, this scandal appears to be in its early stages. It will take months -- perhaps more than a year -- to determine the scope of illegal and unethical fund-trading activity, determine which funds were complicit or unwitting accomplices, and to install new firewalls to ensure fund firms and other parties that execute fund trades can't act in ways that undermine the interests of long-term investors.

As investors track the steady stream of headlines about the unfolding scandal, it's a good time to address several of the big questions.

What Exactly Is the Scandal?

It began when New York Attorney General Eliot Spitzer announced a settlement with Canary Capital Partners, a New Jersey hedge fund, on Sept. 3. In a 44-page complaint, Spitzer alleged Canary engaged in illegal and unethical trading in mutual funds. Canary paid $40 million in fines to settle the charges without admitting or denying guilt.

The big bombshell for the fund industry was that four fund firms allegedly entered into agreements with Canary, allowed the hedge fund to make illegal trades in exchange for Canary's parking millions of dollars into their funds -- which meant more fees for the fund firms. The four firms are

Bank of America's

Nations Funds,

Bank One's

(ONE) - Get Report

One Group funds,

Janus

(JNS)

and

Strong

.

There were two types of arrangements, one clearly illegal and one clearly unethical and potentially illegal. The first arrangement is late trading, which only Bank of America helped facilitate. A fifth party, Phoenix-based trade-execution firm and trustee Security Trust Co., was alleged by Spitzer to have allowed Canary to late-trade.

Here's how late trading works: Unlike stocks, whose prices fluctuate all day, the value of a mutual fund -- called net asset value -- is calculated only once a day, at 4 p.m. ET. Fund trade orders placed after 4 p.m. are supposed to get the next day's price. However, Bank of America and Security Trust allegedly let Canary make "late trades" after the 4 p.m. close but still get the 4 p.m. value, even though news may have come out to affect the fund's value. Average investors who place trades at the same time would get the next day's close. Spitzer's analogy that late trading is like betting today on yesterday's horse race is quite accurate.

Why would they benefit? Let's say that after the 4 p.m. close,

Intel

(INTC) - Get Report

and

Microsoft

(MSFT) - Get Report

posted bang-up earnings that beat estimates, and their stocks traded higher after hours and in the next day's session. Canary illegally rides on the back of the funds' profits, skimming some of long-term investors' gains off in the process. Meantime, the excessive trading adds to a fund's expense ratio.

Market-timing is different. Market-timers take advantage of stale prices in a fund's net asset value -- this often occurs with overseas funds because of differences in time zones. For instance, what if the U.S. markets have a big rally fueled by good news in the tech sector? The overseas markets are closed -- but they are certain to get a big pop because they often take their cue from U.S. markets. Market-timers play a "time-zone arbitrage" and buy the international fund before the market opens, get the almost guaranteed profit, and sell the next day.

While not illegal like late trading, market-timing also skims profits off the top of funds that rightly belong to long-term investors -- and it adds to the total cost of owning the funds because of the heavy trading. Market-timing isn't illegal, but most mutual fund firms say they actively discourage it. Janus, Strong and Bank One allowed Canary to market-time some of their funds, despite including language in their public documents saying they worked aggressively to prohibit that practice in their funds.

Why Is the Scandal Expanding?

Spitzer said in early September that mutual funds are in "deep trouble," and indicated that many other mutual fund firms have been contacted by his office regarding abusive trading issues. The

Securities and Exchange Commission

-- the agency charged with overseeing mutual fund companies -- has sought information from 80 major fund companies and 34 brokerage houses regarding their trading practices.

Fund firms and brokers are now scrambling to determine whether their shops have any bad eggs participating in abusive trading. And it seems plenty of rotten eggs are turning up.

Another hedge fund firm Spitzer was probing was Millennium Partners in New York. A senior trader at Millennium, Steve Markovitz, pleaded guilty earlier this month to the late trading of mutual funds.

Merrill Lynch

(MER)

has fired three brokers who allegedly helped Markovitz trade a group of more than five mutual funds.

Meanwhile, other fund firms have disclosed proactive steps as internal probes turned up dirt.

Fred Alger Management

suspended three employees over concerns that they allowed a client to late-trade its funds.

Alliance Capital

(AC) - Get Report

suspended Gerald Malone, a well-regarded tech fund manager, along with a sales executive for apparently allowing improper fund trading. A dozen

Prudential Securities

brokers were forced out over concerns about market-timing.

It is likely that, as funds examine themselves, more firms may come forward with revelations.

Why Have Vanguard and Fidelity Been Subpoenaed?

The news that

Vanguard

and

Fidelity

-- the two largest fund companies, with more than $1 trillion in combined assets -- have been subpoenaed by Spitzer's office in the scandal has many investors nervous that their trusted fund firms are tainted as well.

FleetBoston

(FBF)

and others have been subpoenaed as well.

But a subpoena doesn't automatically mean something is amiss. Fidelity and Vanguard have issued very forceful statements averring that their firms strenuously fight illegal and unethical trading within their funds, and Fidelity and Vanguard investors have no reason to fret right now.

Why, then, were they subpoenaed? It's highly likely that some of the firms' funds were timed or late-traded, but without the knowledge of Fidelity and Vanguard. According to Spitzer's complaint, Security Trust allowed Canary to execute late trades under the radar -- lumping in Canary's illegal trades with the mountain of legitimate trades that Security Trust executed for the rest of us. Vanguard and Fidelity, and presumably scores of other funds, would have no way of knowing.

What Is This Security Trust Co. and What Is It Doing Trading My Funds?

This is the question that many more people should be asking. Security Trust has received the least media scrutiny compared with the funds in the spotlight. But if Spitzer's allegations prove true, this little-known Phoenix concern may be responsible for the abusive trading that hurt the greatest number of investors.

Security Trust serves a variety of functions in the often murky arena of retirement plans and financial-transaction services. In addition to being a trustee for 401(k) plans, the firm executes trades that mutual fund investors make every day -- they are a platform across which thousands of funds are traded. According to Security Trust's Web site, it trades more than 3,000 mutual funds and handles more than $10 billion in assets for its clients.

According to the complaint, Security Trust let Canary trade hundreds of mutual funds under the radar -- neither funds nor investors had any idea. In exchange, Security Trust allegedly received fees of 1% of custodial assets -- 10 times more than what its other customers paid -- as well as a 4% cut of Canary's illicit profits, according to Spitzer's complaint.

Last month, the firm denied that it had done anything illegal, and responded that Spitzer's office essentially failed to grasp how funds are traded. Security Trust's background, however, isn't holding up well under scrutiny. The firm has been censured three times by state of Arizona's banking department and has been the target of more than a dozen lawsuits over allegations of fraud and breach of fiduciary duty. After a devastating

profile of the company in Friday's

USA Today

, Security Trust Chief Executive Grant Seeger resigned over the weekend.

How Can I Tell If My Funds Have Been Traded, and How Can I Get My Money Back?

Stanford University's Eric Zitzewitz has concluded that investors lose as much as $5 billion a year due to abusive trading; meanwhile, late trading and market-timing at the affected funds may have skimmed as much as 2 percentage points off annual returns. Over the long haul, 2 percentage points is a major cut.

Because of the apparently far-reaching nature of the under-the-radar trading, it isn't clear yet how many and which funds have been traded illegally.

Meanwhile, the funds that were initially fingered in the Spitzer complaint have all come forward with plans to compensate all victims of late trading and market-timing in their funds. It behooves all individual investors to check their mutual fund firms' Web sites for information about abusive trading within their funds. Most trusworthy firms have addressed it in some form -- and fortunately, many of the funds that haven't been touched by this have been pretty emphatic about it. Meanwhile, this is a good time to call the firm's investor help line to get some answers.

Did Executives at the Fund Firms Know?

It isn't clear yet, but this is going to be one of the big questions in the coming weeks -- and it isn't overstating it to say the fate of some of these fund firms hangs in the balance.

The past three years have been pretty brutal for many mutual fund companies, as assets under management withered due to redemptions and stock market losses. Would top executives have known and condoned questionable market-timing practices that nonetheless offered the potential of tens of millions of dollars in new assets?

Bank of America may have signaled how high the trail goes by who has been terminated. Janus and Strong, two firms with fairly flat management structures, "have been very defensive and haven't let anyone go that I'm aware of," said Russ Kinnel, Morningstar's director of research. One possible explanation for why the firms have remained quiet about personal responsibility is determining who signed off on the decisions to allow market-timing within some of their funds.

Will There Be Criminal Prosecutions?

So far, Spitzer filed criminal charges against Ted Sihpol, a broker at Bank of America who allegedly allowed Canary's late-trading activity. If the allegations regarding Security Trust prove true, it would be possible that the responsible party or parties face criminal prosecution. Meanwhile, Millennium's Markovitz pleaded guilty to late-trading.

While the late-trading issue is fairly cut and dry -- the practice is illegal -- it's hard to say if there will be criminal proceedings over market-timing. The question is, will Spitzer see market-timing as a civil or criminal matter? So far, the attorney general hasn't minced words about saying the participants engaged in illegal behavior.

However, it's fairly clear that the unfolding scandal may end up as a bonanza on the civil-litigation side of the equation. Several efforts to file class-action suits against the fund firms in question are under way and more are likely to come.

What Is the Fund Industry Going to Do About This?

In less egregious situations, it tended to brush off demands for greater regulation. However, if nothing else, Spitzer's complaint provides ample evidence that the industry needs greater regulation.

The good news is that the Investment Company Institute, the industry's leading trade group, has indicated that it is serious about cleaning house. Last week, the ICI's executive committee set up two task forces -- one to examine what needs to be done to prevent late trading, the other to examine how to curtail market-timing.

"It's clear that fund companies should be getting the message that they have to rediscover their traditional role as long-term stewards of investors' capital," Kinnel said. "It also points out how much fund boards have let investors down."

Yes, Why Didn't Fund Boards and Regulators Prevent This?

Hopefully, one of the beneficial developments from this scandal will be that fund firms and individual investors take a closer look at the boards of directors that are supposed to be independent -- and are supposed to be the first line of defense for investors' interests.

Mercer Bullard, the dogged mutual fund activist who runs Fund Democracy, a fund-investor advocacy group, has complained that the steps several fund firms are now taking don't measure up. Why? Because Janus and others are appointing panels led by independent directors of the board to probe how things could have gone awry. Bullard notes, rightly, that these independent directors snoozed through their first chance to answer this question -- now, it's clear true outsiders are needed. Former SEC Chairman Arthur Levitt suggested that the boards of the fund firms involved should consider resigning as part of any settlement.

It seems a fairly sad commentary that one of the ICI's two additions to the fund industry's "best practices" list unveiled Monday was to suggest prohibiting "close family members" of fund employees from serving as independent directors. Doesn't that seem fairly obvious?

Too many independent directors have served multidecade terms and are in their 70s -- the cynical view that a gig on a fund firm's board is a cushy, well-paid one that entails little ombudsman activity is sadly accurate in many instances.

Regarding the regulators, Spitzer's pursuit of these funds has awoken the SEC, which has been fairly criticized for not doing enough to ensure that fund firms are looking out for individuals' best interests. Hopefully, the commission will be given more money to put a little fear into fund firms -- Spitzer certainly has done so.

What Effect Will This Scandal Have on the Stock Market?

It's a good thing the mutual fund scandal didn't unfold during the summer of 2002, when the market was hitting its nadir amid a slew of corporate scandals. If investors were dealt with the dual blow of corporate scandals and mutual fund shenanigans, there may have been a run on the banks.

In the meantime, the mutual fund industry remains the best option available to individual investors looking for access to Wall Street. And it seems likely that the reputable investment firms -- the

T. Rowe Prices

(TROW) - Get Report

, the Vanguards, the

Dodge & Coxes

, the

Eaton Vances

(EV) - Get Report

and so on -- will come out looking cleaner than ever.

The most important shift may be an acceleration away from actively managed funds toward low-cost, passively managed alternatives such as index funds and exchange-traded funds.