The mutual fund industry's reaction to the allegations that at least four mutual fund firms have allowed hedge funds to reap millions of dollars in profits by illegally trading in fund shares was best summed up by Vanguard founder John C. Bogle: "What the hell were they thinking?"

On Wednesday, New York Attorney General Eliot Spitzer announced a $40 million settlement with a New Jersey hedge fund, Canary Capital Partners, over allegations that it engaged in illegal trading in mutual fund shares sold by a number of Wall Street firms and banks, including Bank of America's ( BAC - Get Report) Nations Funds, Bank One ( ONE - Get Report), Janus Capital Group ( JNS) and privately held Strong Capital Management.

Spitzer said the charges against the hedge fund are the beginning of a continuing investigation that likely will result in further charges against mutual fund companies.

"Mutual funds," said Spitzer, "are in deep trouble."

The events have the industry distressed, according to John Collins, spokesman of the fund industry trade group the Investment Company Institute. "We take this extremely seriously," said Collins. "The fund industry is in the position of having to earn the trust of investors every day, and this is a violation of a very clear law."

Mercer Bullard, founder of fund-investor advocacy group Fund Democracy and author of two TheStreet.com articles cited in the complaint, said the $40 million settlement reached with Canary is just a prologue to a much larger battle with mutual funds. "This is a mutual fund issue," Bullard said. " Spitzer just rolled the hedge fund in preparation for going after the fund managers, where any settlement would be in the multiples of the $40 million deal."

The ICI's Collins said industry leaders will meet "soon" and exchange their views on addressing Spitzer's probe and the challenges facing the industry.

The mutual fund firms named by Spitzer were fairly quiet Wednesday -- their responses stuck largely to brief news releases. Janus, for instance, said in a statement that it "intends to continue cooperating with the New York attorney general's inquiry. Janus is reviewing the complaint closely and is committed to ensuring that the company continues to act in the best interest of Janus fund shareholders."

Likewise, Bank One said, "We will look into the issues raised by the allegations against the hedge fund, and will cooperate fully with the Attorney General's Office." Spitzer's office said other fund firms are being investigated, but he declined to name them.

Comments from fund firms and industry watchers ranged from disavowals of the practices alleged in Spitzer's complaint to dismay and disbelief, along the lines expressed by Bogle.

"I can't imagine that 'late trading' is pervasive; however, I can't imagine that even one company would allow it," said Russ Kinnel, Morningstar's director of fund research. "It's absolutely amazing."

Two Issues

Most fund watchers noted the distinctions between the two activities at the center of the scandal -- "late trading" and "market timing" of mutual funds.

The late-trading issue is the more egregious matter, most analysts agree. Late trading, which is illegal, enables a trader -- in this case, the hedge fund -- to purchase shares in mutual funds after the 4 p.m. close but at their 4 p.m. price. What's the angle? Well, this allowed Canary to buy the fund shares after important news such as earnings announcements of companies held within the fund but before the fund's net asset value was changed to reflect the stock moves.

Spitzer's analogy sums up late trading best: "Betting on a horse race after the horses have crossed the finish line." And, Spitzer said, his investigation found that this kind of illegal trading between hedge funds and mutual funds is more common than previously thought.

With late trading, "there's a predictability in fund prices that almost guarantees you profit," said K. Geert Rouwenhorst, a professor at the Yale School of Management who has studied late trading extensively over the past decade. "Our research found the strategy earns you 30% a year vs. long-term buy-and-hold fund investors and cuts the risk in half."

This hurts long-term investors because it allows late traders to participate in the profits that otherwise would have gone completely to the fund's buy-and-hold investors.

In this instance, Bank of America's alleged behavior looks especially troubling. According to Spitzer's complaint, Bank of America installed special computers in Canary's office that allowed it to late-trade Bank of America's Nations Funds in exchange for Canary's stashing millions of dollars in Bank of America's bond funds.

Market timing with mutual funds is an arbitrage strategy that allows savvy traders to take advantage of the time differences between the closing of the U.S. markets and foreign exchanges. "I'm not surprised that some fund firms are allowing market timers," Morningstar's Kinnel said. "The biggest surprise was Janus wasn't merely not enforcing market timers, but that they were consciously choosing to do this and calculating how much it was adding to their bottom line."

Kinnel referred to alleged email exchanges between a Janus employee and Janus International CEO Richard Garland contained in Spitzer's complaint. "I have no interest in building a business around market timers, but at the same time I do not want to turn away $10-$20m!" Garland wrote, according to the complaint. Garland gave the go-ahead to Canary to engage in additional market-timing capacity on April 3, 2003, after learning that it could net Janus between $10 million and $50 million, but the deal was never finalized.

Several mutual fund firms take strides to deter market timers from trying to exploit their funds' pricing for quick, sure profits that hurt individual investors. The measures include fair-value pricing of their funds that makes it nearly impossible to trade on value discrepancies -- firms such as Vanguard, Fidelity, Putnam, Eaton Vance and American Century employ this fair value pricing. Other measures include imposing early-redemption fees and trading limits.

"We do not engage in any late trading, and do everything we can to keep market timing out of our funds," said Meg Pier, a spokeswoman for Eaton Vance. A spokeswoman for Vanguard echoed these sentiments, saying "we have turned away tens of millions of dollars in investments in our funds because they don't pass our screens on market timers."

Meantime, the fund industry is mobilizing to head off any damage that the latest scandal might bring. "This complaint cuts very close to the very heart of the way funds protect their shareholders: Treat all investors the same," said the ICI's Collins, who said the fund industry will move quickly to head off the behavior Spitzer detailed.

Bogle, meanwhile, took the firms to task. "I would call this a breach of fiduciary duty that comes as close to theft as you can imagine," he said, adding, "If I were a shareholder, I would be discouraged, disgusted and giving real consideration to putting my money somewhere else."