Sep. 7–The scandal-a-week machine on Wall Street served its latest offering Wednesday, when New York Attorney General Eliot Spitzer accused Bank of America and other firms of cheating mutual fundinvestors to gain business from a favored client.

The new allegation is especially disturbing because it focuses on a mutual fund companies.

Funds are supposed to be the safe haven for small investors. By spreading your investment among dozens or hundreds of stocks, a fund ought to minimize the damage done by fraud involving any one stock. That protection is lost if the fund company is breaking the rules itself.

There are some ways small investors can guard against this kind of thing. I’ll get to that. But first, what happened in this case?

The complaint filed by Spitzer alleges two offenses. The most serious is the illegal practice of “late trading.”

In exchange for getting other business from one client, Canary Capital Partners, Bank of America allowed the New Jersey hedge fund to buy and sell the bank’s funds after the financial markets had closed at 4 p.m., the complaint says. (The bank said it is cooperating with investigators and is “in the process of determining all of the facts.”)

Ordinarily, an investor who places a buy or sell order for fund shares at, say, 10 a.m., gets the price calculated after that day’s close, based on the closing prices of all the stocks and bonds held by the fund.

If the investor’s order is placed after the close — at 4:15, for example — the price paid will be based on the net asset value figured after the close the following trading day.

The complaint says the bank allowed Canary to place orders after 4 p.m. but still get that day’s price. This allowed Canary to act on news that broke after 4 p.m. and virtually guarantee profits — like betting on a horse after the race is finished, as Spitzer put it.

Companies often wait until after the market’s close to announce important news that can drive stock prices up or down, such as quarterly profits, mergers or lawsuits. This gives investors overnight to digest the news.

Canary, the complaint says, would buy the Bank of America funds after the market close, get that day’s price, then sell the next day after the news had driven up the fund’s share price. Or Canary could sell before bad news drove the price down.

Canary’s profit would be paid out of the fund’s assets — reducing the value for all other investors.

The second allegation involves “timing” of fund purchases. While not necessarily illegal in itself, timing violates securities regulations if a fund company tells investors it has policies forbidding it, as Bank of America did.

The complaint says Bank of America allowed Canary to make quick in-and-out trades that other investors were not permitted to make. It could, for instance, buy a fund that held a lot of Japanese stocks in order to benefit from a sudden gain in those stocks’ prices. Because Japanese markets close 14 hours before American markets, the net asset value of such a fund is usually based on day-old prices, so the in-out maneuver allowed Canary to lock in virtually guaranteed profits.

Again, Canary’s gains came at the expense of the fund’s other shareholders who didn’t have the same priviliges. The bank said Canary was the only investor “with which we had an agreement to permit market timing in our mutual funds.”

Canary has neither admitted nor denied guilt, but agreed to pay $30 million restitution for illegal profits plus a $10 million penalty.

In the multi-trillion dollar fund industry, an investor loss of $30 million isn’t much. But it’s fair to wonder how widespread such practices are, and whether fund companies that engage in one kind of favoritism have also cooked up others we don’t know about.

Spitzer’s office said such schemes “potentially cost mutual fund shareholders billions of dollars annually.” He’s broadening his investigation to look at other fund companies. The Securities and Exchange Commission is starting a probe as well.

In the meantime, small investors can help protect themselves by keeping in mind the benefits of diversification. The more investments you have, the less you’ll be hurt if something goes wrong with any one of them.

In this case, it means owning funds that contain lots of stocks. Late-breaking news can dramatically drive a stock’s price up or down. But if it is just one among hundreds of stocks in the fund, the news will have little effect on the fund’s share price. Such a fund is, therefore, not a good candidate for the kind of game Canary was allegedly playing.

Volatile funds — those prone to wide up and down price swings — are more likely subjects for such schemes, since money can be made on short-term price changes. Funds that invest in small-company stocks, foreign stocks, or stocks in industries like the Internet that run hot and cold, are more volatile than funds that invest in big U.S companies and mainstream industries.

I’m not saying you shouldn’t have a small portion of your porfolio in these more volatile funds. But if you want to buy them, you now have a new risk to consider.

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