NEW YORK (CNN/Money) - Active managers were a rare breed even before the mutual fund scandal erupted. Now they may need to go on the endangered species list.
The number of funds alleged to have allowed some investors to engage in late trading and market timing trades is growing, it seems, by the day. The latest hit: The two founders of Pilgrim Baxter -- a fund company whose name was once synonymous with the momentum-style investing that flourished in the late 1990s -- stepped down Thursday after an internal investigation revealed they were connected to timing trades.
The scandal doesn't appear to have affected investors' penchant for investing -- the stock market has fared well and funds have seen steady inflows since New York Attorney General Eliot Spitzer launched his first broadside against the fund industry in September. But it may change the way people invest, and that could change the tenor of the market for years to come.
Consider the public funds that have already withdrawn their money from the likes of Putnam. In all likelihood that money went right back into the stock market (public funds don't change their stock allocations on a whim), but how? Some probably went back into actively managed mutual funds, but it's a good bet that a fair amount went into index funds and exchange-traded funds, like iShares and SPDRs. Costs are lower than actively managed funds, and nobody is playing games that cheat investors out of returns that rightfully belong to them.
Many individual investors may follow suit. With the scandal's eruption, a staple story in the investing press has been to suggest the switch to indexes and ETFs. Financial advisors who count high-net-worth investors as their clients have been singing the same tune.
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But if investors crowd into indexes and ETFs, what we may see happen in the market may be akin to group-think. Stocks that are index members, or are in the (typically index-based) baskets that ETFs represent, will have steady buyers. Stocks that are not will often be neglected by investors, making them far more volatile and, perhaps, more under priced than they might otherwise be. Stocks that manage to migrate their way into an index will see even bigger pops when they get added. Stocks that get dropped will see even bigger declines.
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