NEW YORK (CNN/Money) - Market timing, late trading, millions of dollars in average investors' money lost because of secret, sometimes illegal, arrangements between mutual funds, hedge funds and brokers.
At first glance, the burgeoning investigation started by New York State Attorney General Elliot Spitzer has all the markings of the next big scandal on Wall Street, an encore to Spitzer's two-year probe into the too-close ties between stock analysts and investment bankers that resulted in a $1.4 billion settlement this spring. Since Spitzer first announced his probe nearly two months ago, the Securities and Exchange Commission and the Massachusetts Secretary of the Commonwealth William Galvin have joined in with probes of their own.
But this time, investors are shrugging off the almost daily news of subpoenas, criminal and civil charges, and dismissals of fund managers, brokers, and hedge fund investors.
"It's much ado about nothing in some respects," said Rick Applegate, a certified financial planner and president of First Commonwealth Financial Advisors in Indiana, Pa.
What gives? For one, damages to individual investors caused by market timing or late trading allowed by mutual funds will be very small, often amounting to one or two percent lower returns on their investment. Most funds alleged by Spitzer, Galvin and the SEC to have allowed market timing or late trading of their shares have pledged to restore the money individual investors might have lost. Most individual investors have few options, other than mutual funds, for building up their retirement nest eggs.
And market timing – the rapid-fire trading of mutual fund shares that takes advantage of short-term pricing inefficiencies – while often violating the funds' fiduciary responsibilities to their investors, is not illegal. What's more, there are many legal actions a fund can take -- raise fees, hire poor managers, not close to new investors after growing too much in size -- that could hurt investors much more.
"Relative to the $7 trillion mutual fund industry, it's very little money, maybe one or two percent in returns," said Wharton School finance professor Jeremy Siegel.
According to a recent paper by Eric Zitzewitz, assistant professor of economics at Stanford University's Graduate School of Business, long-term shareholder losses caused by late trading amounted to about 5 basis points in international stock funds and 0.6 basis points in domestic stock funds – or, if diluted across the funds industry, about $400 million a year. Unlike market timing, late trading, which involves trading mutual fund shares at their 4 p.m. closing price after 4 p.m., is a crime.
By contrast, when well-known Wall Street analysts hyped worthless stocks for the sake of gaining investment banking business for their companies, the damage caused to investors was much greater. Thousands, who trusted research by the likes of Merrill Lynch's Henry Blodget and Salomon Smith Barney's Jack Grubman, saw their life savings evaporate the when the bubble burst and the bear market of 2000-2002 struck.
What to do
Individual investors seeking good returns on their retirement savings still have no better option than to put their money mostly in mutual funds, investment advisers and fund experts said.
This doesn't mean that investors should keep their money in some of the funds implicated in Spitzer's probe. But before pulling out, they should consider things like the tax consequences of selling their shares, as well as the overall track record of the fund over an extended period of time -- 10 years of solid returns under the same management would make a good argument for staying put in your fund, according to Applegate.
Russell Kinnel, director of fund analysis at Morningstar, said investors should look at positive criteria when picking a fund – low costs, and/or funds whose managers have a good deal of their own money invested in them.
In recent reports, Kinnel has recommended that investors avoid Alger and Alliance funds – both fund families involved in the market timing probe. Morningstar has also recommended to investors to stay away from the original four fund families implicated in Spitzer's probe: Janus, Strong, Bank of America and Bank One.
Because investing in mutual funds is less risky than betting one's money on individual stocks and more rewarding that saving at a bank, senior Lipper analyst Don Kassidy thinks investors should stay the course, be selective, and stick with mutual funds. The funds he thinks are safer, especially for investors leery of the market timing problems, are those less likely to attract such activities – exchange traded, closed end and maybe index funds.
"Using this as an excuse not to invest will prove very short-sighted," said Kassidy.
According to a CNN/Gallup poll conducted this week, investors are listening: 67 percent of respondents in the poll said the investigation would make no difference in their decision whether or not to invest in mutual funds. But 51 percent of respondents also said that they would probably move their money out of a fund that is under investigation.
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