Nov. 23–If you own mutual funds, there’s a very good chance you’ve been robbed.

That’s right, robbed.

Nobody knows exactly how much was taken. But robbery is, in essence, what the widening mutual-fund scandal amounts to.

Since September, regulators have alleged that fund managers and stockbrokers improperly gave favored clients, such as hedge funds, trading deals that allowed them to profit at the expense of mom-and-pop investors. In some cases, the watchdogs say, fund managers and brokers conducted this trading themselves and kept the money they skimmed.

While no one has been found guilty or admitted wrongdoing, a string of high-profile suspensions and resignations has lent credibility to regulators’ charges. Some companies already are agreeing to pay restitution to investors who’ve lost money.

The fund companies cited so far are some of the most popular with investors: Janus, Putnam, Bank of America’s Nations Funds, American Express, Bank One, US Trust, Federated Investors and Loomis Sayles. Regulators also are probing brokerage firms that allegedly aided or engaged in the trading schemes, including Morgan Stanley, Charles Schwab and Prudential Securities.

“It’s bad stuff — and it’s bad that it seems to be pervasive,” said John Bogle, founder of the Vanguard family of mutual funds and one of the few outspoken critics inside the industry.

The questions the scandal raises are as troubling as they are complicated and affect an industry entrusted with a huge portion of the nation’s savings, much of it in 401(k) retirement accounts.

Mutual funds manage money for 95 million Americans and hold $7 trillion of their money, an amount equal to about two-thirds of the nation’s total economic output for a year.

Why did this happen in an industry people thought was the epitome of safe? How far did it go? What did it cost? And what can investors do?

–What are mutual funds? The concept of mutual funds is simple: Investors pool their money and use the resulting economies of scale to buy an array of stocks or bonds they otherwise couldn’t afford, spreading their risk across many investments and people.

–Who owns the fund? Investors own the money in the fund. But the fund entity itself is usually owned by a separate group of people who own the fund company. The owners of Janus funds, for example, are the shareholders of Janus Capital group, a publicly traded company, not the fund investors. It’s the difference between a “mutual” company owned by members and a private company owned by outside shareholders. Most “mutual fund” companies are actually not “mutual” at all. They’re privately owned and managed to make a profit.

–Who runs the fund? A fund manager, someone seasoned in the ways of Wall Street, invests the money. The manager deducts a fee from the pool of money and tries to match or beat the market, which may be defined by benchmark indices like the Dow Jones industrial average.

What many people don’t understand is that fund managers don’t answer to the individual investors in the fund. Sure, they have a duty to look out for the investors. But the fund managers’ real bosses — the people they have to please to keep their jobs — are the owners of the fund companies. They are hired by and report to this separate group of people who’ve invested in the fund company, as opposed to its funds.

What’s wrong with that? The structure puts fund managers in an obvious conflict of interest with those in the mutual-fund pool.

Fund managers answer to company executives and shareholders, who naturally want a good return on the stock price of the company. What produces a good stock price? Profits for the company. How does the company make profits? By charging those in the pool high fees and increasing sales by setting up new funds and encouraging investors to put more money into them.

That fundamental conflict has shifted priorities and opened the door to abuse, experts say. It isn’t surprising that fund companies don’t like to talk about it.

“We’ve turned an industry of stewardship into an industry of salesmanship,” Bogle said.

How individual investors lose out

Under pressure for profits, fund companies skimmed money using two schemes: market timing and late trading. Both take advantage of the fact that the price of a mutual fund, unlike an individual stock, is set only once a day. The price is simply the value of all its stocks divided by the number of investors.

What is market timing? A practice of rapidly buying and selling fund shares to take advantage of “stale prices” of foreign shares is called market timing. U.S. funds that buy foreign shares are priced at the end of New York trading, many hours after foreign markets close. If U.S. markets rally, it’s a safe bet foreign stocks will rise tomorrow.

Market timers buy today, knowing the funds are undervalued, and then sell them the next day, when they rise. These profits comes at the expense of other investors in the fund, who are essentially selling shares to market timers at the low price, and buying shares again at a higher price the next day. The Securities and Exchange Commission recently said that about half of mutual-fund companies and nearly 30 percent of broker-dealers engage in market timing. Another 40 percent, the SEC said, know about market timing and may let customers engage in it, even if they don’t do it themselves.

Other estimates are higher. Eric Zitzewitz, an assistant professor at Stanford University who has studied mutual funds, said 90 percent of mutual funds in his sample engaged in market timing.

Who benefits? Regulators allege that one of the biggest market timers was Canary Capital Partners, a New Jersey hedge fund. Hedge funds are lightly regulated and often attract money from rich folks who can afford to take a little more risk.

But market timing was carried out for other big institutions, which typically ask for the favor in exchange for putting a chunk of investment money with the fund company for a longer period.

And, in many cases, regulators allege that fund managers, brokers and fund-company executives engaged in market timing for their own personal accounts, violating the trust placed in them as stewards of those investments.

Who loses, and by how much? Zitzewitz figures market timing costs long-term fund investors $5 billion a year in trading losses — or about 1.1 percentage points of the annual return of long-term fund investors. If an investor was earning 10 percent a year on the fund, market timing would knock that down to 8.9 percent. The figure covers just money lost to favored investors. It excludes higher trading costs, tax charges and other expenses that funds rack up by allowing market timing.

Is this legal? This quick in-and-out trading to capture small gains is called arbitrage. While legal, and widely practiced in the world of stocks, it is considered improper for most mutual funds because it harms other investors. Documents released by New York Attorney General Eliot Spitzer, who helped launch the probe of fund scandals in September, show how casually officials at Bank of America, Janus, Putnam Investments and others handled market timing.

“Our stated policy is that we do not tolerate timers,” a Janus official said in a June 11 e-mail released by Spitzer. “As such, we won’t actively seek timers, but when pressed and when we believe allowing a limited/controlled amount of timing activity will be in (Janus’) best interests — increased profitability to the firm — we will make exceptions.”

Another Janus official later wrote: “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(illion)!”

How can I find out if my fund does this? You probably can’t. All mutual funds are supposed to tell investors what they’re doing. But many don’t tell the truth.

“None of the funds that appear to have special market-timing arrangements has specifically disclosed the existence of the arrangements” to investors, Stephen Cutler, the SEC’s chief of enforcement, told Congress earlier this month.

In fact, most fund companies state that they refrain from or discourage the practice, since it raises costs for other investors. Investors should ask the fund companies specifically about this.

What is late trading? This occurs when investors buy or sell mutual-fund shares after the fund has closed for the day. In essence, they go back in time and buy before a market-moving piece of news. In one form of this trade, investors submit “buy” and “sell” orders for the same number of mutual-fund shares before the markets close on a day when market-moving news is expected after the fund closes. When the news comes out, they cancel one of the orders.

“Allowing late trading is like allowing betting on a horse race after the horses have crossed the finish line,” Spitzer said.

Who benefits? Again, hedge funds or other large investors are granted the privilege, often in exchange for putting some money with the fund company or broker. In some cases, brokers and fund managers also may have engaged in late trading.

Who loses, and by how much? The practice costs other investors in the mutual fund because they are in essence selling to the late traders at an unfairly low price or buying at an unfairly high price. Zitzewitz reckons this costs fund investors $400 million a year. (Late trading doesn’t happen with stocks because stocks trade continually. Market-moving news released after the close of trading simply alters prices in after-hours trading.)

Is this legal? No, it’s illegal. But regulators haven’t banned order cancellations. In fact, they’ve made late trading easier, by allowing fund companies and brokerages to process orders for many hours after the official close. The lengthy process creates plenty of opportunities for people along the processing trail to game the system.

“A lot of the business comes in at 6 or 7 at night in the ordinary course of business,” Bogle said. “Some of it doesn’t come in till the next morning. We assume it’s innocent. But who’s to say when the order comes in whether, within that bundling, some guy that works at the clearing agency hasn’t put his own order in?”

How can I find out if my fund does this? Again, you probably can’t. Since it’s illegal, all companies will say they don’t do this.

How can these trading schemes be identified? Market timing and late trading are easy to catch. Investors need only look at cash flowing in and out of a fund to see whether large sums arrived just before market-moving news, or after a move in overseas markets. But most mutual-fund companies have resisted sharing daily data with investors. They release it monthly, and some have pulled back from that since the scandals broke.

The SEC is expected to propose rules to correct both practices later this month, and the changes could be approved as early as next year.

Bogle believes fund companies should stop accepting new orders at 2:30 p.m. New York time so orders could be processed before the closing price is set at 4. Releasing daily fund-flow data also would help curb abuse, he says.

Another proposal calls for a selling fee to discourage quick in-and-out trading by market timers. Sellers would pay only if they sold a few days after they bought. However, big customers would undoubtedly pressure fund companies to waive such a fee.

Lost in much of the discussion over mutual-fund abuse is the role of stockbrokers. In some cases, they are the ones carrying on late trading or market timing of funds without the funds’ knowledge, either for their individual-investor customer or for themselves. Prudential Securities, Merrill Lynch and Citigroup’s Smith Barney unit have fired 19 brokers who allegedly engaged in market timing or late trading.

“The fund industry is getting the public black eye, and they weren’t alone for this,” an SEC spokesman said.

The House of Representatives last Wednesday passed a bill that requires fund companies to more-closely detail their fees and forces fund managers to reveal whether they own shares in the fund. It also demands that independent directors make up two-thirds of a fund-company’s board, rather than half as required now. But many say this bill lacks many of the elements needed to police the industry.

Market timing and late trading have taken more than $5.4 billion from long-term mutual-fund investors. But those losses are relatively small when compared with what investors lost on Enron or WorldCom shares, which plunged on news of accounting fraud.

Why have shares of mutual funds held their value? The share prices of most mutual funds are based on the underlying stocks, bonds and cash they own, calculated at a certain time once a day. Unlike stock buying and selling, mutual-fund share prices aren’t directly affected by people buying or selling the fund shares.

Putnam Investments’ mutual funds prices, for example, have hardly moved in recent days, even as investors have pulled more than $21 billion from its funds and its chief executive, Lawrence Lasser, has resigned.

But concern about the eventual fallout is rising as the scandal widens. This month, Putnam Investments, the first company to be charged with securities fraud in the investigations, offered to settle and the SEC agreed, drawing howls from critics who said the quick deal lacked teeth beyond reforms Putnam was likely to adopt anyway.

Putnam didn’t admit wrongdoing, even though the SEC said at least six Putnam fund managers engaged in short-term trading to benefit their personal accounts as far back as 1998. It agreed to compensate investors, but didn’t say how much. The scandal has made many investors rush to get out of Putnam funds.

But others are unsure what to do. While they’ve lost faith in management, the funds are still making a return.

What should investors do now? With so much of the fund industry tainted or under suspicion, should investors move their money and incur transaction fees?

“That’s a tough one,” said Karl Ege, general counsel at Frank Russell, the Tacoma company that rates fund managers. He said the company is giving lots of advice to its big institutions, but isn’t sharing that advice with the public.

Without such guidance, “people are confused about which way to go,” said Tom Roseen, a research analyst at Lipper, a mutual-fund tracking company in Denver. “I don’t think people are shrugging off the legality issues, but where can they go at this point?”

Even managers of big pension funds are wondering. The Washington State Investment Board has decided to pull $584.6 million invested with Putnam under a fund manager who was dismissed amid the scandal. But despite the decision and concern at Putnam’s loss of integrity, Executive Director Joseph Dear isn’t rushing for the exit. Dear knows moving to a new fund company would cost several million dollars in transaction fees. He doesn’t want to move money until he knows where to put it. Pulling it out quickly and storing it in an index fund or other investment would simply cost the pension system more fees.

There are no easy ways to tell if fund managers are being honest. But funds with good reputations, low fees and low turnover rates are a good place to start, experts say.

And high-turnover funds are probably good to avoid. American AAdvantage International Equity Fund, for example, had $1 billion in redemptions on $102 million in assets last year. In essence, the money in the fund turned over 10 times.

While that doesn’t prove the fund was market timing or late trading, Roseen said, “Obviously there’s been some churning going on.”

WHAT TO LOOK FOR

As regulators widen their probe of mutual funds to more companies, investors are wondering whether to move their money, and to where. Here are factors experts say are signs of good-quality equity funds. Their presence doesn’t mean a company is honest any more than their absence means it is crooked. But odds are better when funds stick to these fundamentals.

Low fees: Since fund fees are charged to the investment pool, they directly reduce the fund’s performance and return to investors. Experts recommend funds with low fees.

–Low turnover: Funds with high rates of redemptions relative to their size are likely to be seeing lots of investors buying and selling. This churning is expensive for investors who want to buy and hold. Best to avoid.

–Fund performance: The classic measure of fund performance tells you how much the fund earned, usually in increments of one, three, five and 10 years. Instead of picking the top-earning fund, look for those that have been consistent performers over the long haul. Also, look for how well a fund does in a downturn. Funds that lost less during the post-2000 stock market decline probably have good managers.

–Transparency: What information does the fund company make available? If it publishes fund inflows and other details, your level of understanding is much higher.

–Funds under suspicion: While funds may be innocent until proven guilty, investors aren’t waiting to render a verdict. They’ve yanked more than $15 billion from Putnam Investments since it was charged last month, and millions more from other fund companies under investigation. While such withdrawals don’t immediately harm investors, they show a lack of confidence and will force remaining investors to shoulder the cost of those redemptions.

–Stable, reliable management: Hard to determine, but look for managers who have been around for many years and for companies with reputable names.

–Index funds: Unlike actively managed funds that try to pick winning stocks, index funds simply try to match major stock-market indexes, such as the Standard and Poor’s 500. Since they don’t require active management, fees are low. Studies have shown that, over time, very few actively managed funds beat these index funds, so paying fees for active management can be a waste of money.

Other resources: Morningstar and Lipper both research mutual funds for consumers. Their Web sites provide detailed information on fund performance, management companies and risk, among other things. At Morningstar, www.morningstar.com, click on the “funds” tab for the company’s latest take on the fund scandal. At Lipper, www.lipperweb.com/usa/products/products.shtml#8, click on links to research reports, industry data and screening tools.

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