Oct. 26–LITTLE GUY’S TRUST IS AT STAKE: Mutual funds are supposed to be the safe haven.

Investing in a pool of stocks, people have been advised, avoids the risk and volatility of buying shares in a single company. And it keeps small investors out of the rough and tumble of a daily market dominated by the big guys.

The pitch has worked.

Mutual funds have become the main investment vehicle for half of all U.S. households. There are 95 million fundholders in the $7-trillion industry.

That’s why the widening investigation into the mutual fund industry has caught a lot of people’s attention. And that’s why regulators who seem to have been caught off guard by the abuses must move quickly to dig out all the corruption.

“Anything that undermines credibility is bad for stocks, especially if the little guy says ‘I can’t trust the market,’ ” said Dave Louton, professor of finance at Bryant College.

The abuses in the buying and selling of mutual funds have been uncovered not by federal regulators who are charged with policing the industry, but by two ambitious, headline-hunting politicians.

New York Atty. Gen. Eliot Spitzer and Massachusetts Secretary of State William F. Galvin have targeted some of the biggest asset managers in the business — Fidelity, Putnam and Morgan Stanley — in their mutual fund probes.

Both public officials may have their eyes on higher office, but the abuses they have found carry weight. And in this case, the politicians have correctly used the public megaphone they carry to prod regulators to act.

Their civil and criminal probes are focused in two areas — late trading and market timing. Those practices hurt all mutual-fund shareholders because late traders and market timers take a bigger slice of a fund’s gains.

And they profit by exploiting the way funds are bought and sold.

The prices of mutual funds are set once a day, at 4 p.m. Eastern Standard Time. If funds are bought or sold before 4 p.m., the investor gets that day’s 4 p.m. price. If he buys after 4 p.m., he’s supposed to get the next day’s price.

Spitzer has uncovered evidence that late traders have bought and sold mutual funds after the 4 p.m. price-setting time, but have received the 4 p.m. price.

That gives them an unfair advantage because market-moving news is often disclosed after the stock market closes at 4 p.m.

By back-pricing what they buy or sell, big investors trade and make money on information not available to other investors. Or if small investors have the information, they are locked into to buying at the next day’s price.

Back-pricing is illegal.

And the practice usually requires collusion between the investor and the broker who executes the trade. There’s evidence that brokers have participated in the schemes to curry favor with big investors.

The other abuse — market timing — involves investors jumping in and out of funds, sometimes dozens of times a day, based on the smallest piece of fresh information that moves the price.

That’s not illegal. But many mutual funds have policies that prohibit the practice because it creates transaction costs and expenses that weaken the returns for other investors.

And it creates two standards of behavior — one for long-term investors and the other for short-timers who make multiple daily trades and profits based on information not available to everyone.

The investigations of the two practices are in their early stages and it’s still unclear how widespread the abuses are, or if there are other illegalities to be uncovered.

After the headlines generated by the subpoenas issued by the politicians, the U.S. Securities and Exchange Commission deepened its probe.

Another area federal regulators are looking at is the disclosure of a fund’s portfolio to hedge-fund operators, who then trade on the information and make money.

Investors already know about CEOs who misled investors, Wall Street analysts who sent out bad information for personal profit and auditors who covered up rather than revealed holes in a company’s balance sheet. All that tarred individual companies and their stocks.

Mutual funds were supposed to be different. The game was supposed to be fairer.

“Mutual funds are still the best investment for the little guy,” said Louton, the Bryant professor. “But to stay that way, regulators have to bring the abuses to light and quickly fix the problem.”

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(c) 2003, Providence Journal, R.I. Distributed by Knight Ridder/Tribune Business News.

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