Making Sense of the Mutual Fund Scandal Everything you may not want to ask (but really should know) about the crisis that's rocking the investment world.
By Janice Revell; David Stires

(FORTUNE Magazine) – The mutual fund business has long portrayed itself as a model citizen in the sometimes seamy world of financial markets. But the avalanche of allegations charging abusive behavior in the $7 trillion industry over the past few months has been enough to shake any investor's faith. Congressional hearings in early November painted a picture of a business awash in conflicts of interest and self-dealing, where insiders profit at the expense of ordinary investors--"the world's largest skimming operation," as one Senator put it.

What is in danger of getting lost in the almost daily drumbeat of subpoenas and executive resignations, however, are the consequences for the nation's 95 million fund investors. Since the scandals center on practices--like unsanctioned market timing and late trading--that are typically the province of insiders, their effect on the average investor is not always obvious to the untrained eye. To make sure you have enough information to navigate this scandal, we provide answers to frequently asked questions and advice on how to get through unscathed.

How did the scandal get started?

The crisis erupted in September, when New York attorney general Eliot Spitzer alleged that four mutual fund companies had struck illicit relationships with Canary Capital Partners, a New Jersey hedge fund. Spitzer charged that Bank of America's fund business allowed Canary to trade several funds after the markets had already closed at that day's prices. Known as "late trading," this illegal practice allowed Canary to trade on after-hours news (such as earnings announcements) at before-closing prices. Spitzer also charged that Banc One, Janus, and Strong (see "Up Against the Wall") allowed Canary to quickly jump in and out of their mutual funds to make a fast profit, a practice known as "market timing." While market timing is not illegal per se, fund companies can violate securities law if they state in their fund prospectuses that they discourage market timing but then make exceptions for "select" investors or their own employees.

How does market timing work?

Market timing is especially common in international funds, where investors attempt to exploit price discrepancies in a fund's net asset value due to time-zone differences. Say there's a big selloff on Monday morning in the Japanese stock market. Hours later, after the Japanese market has closed, U.S. stocks rally heavily in New York. Market timers, assuming there's a high likelihood that stocks in Japan will follow the U.S. lead, buy shares of a "Japan fund" just before the markets close on Monday afternoon. Thanks to the time-zone difference, the fund's net asset value is still based on the depressed Japanese share prices. If Japanese stocks rebound on Tuesday, they'll quickly sell their shares and get a handsome return.

How does market timing hurt long-term investors?

Consider the above example. By the time the market timers' money flows into the Japan fund on Monday afternoon, it's too late for the portfolio manager to put it to work by investing it in new securities (the Japanese market is already closed), so the new money is parked in cash. Now assume that on Tuesday, the Japanese stock market zooms, and the fund's holdings increase in value by 10%. The market timers unload their shares for a nice profit. But because their money--not invested at Monday's lower prices--contributed nothing to the fund's return, the per-share profits of the fund's existing shareholders are diluted.

Other costs are associated with market timing too. If the portfolio manager doesn't have enough cash, he might have to sell shares to meet redemptions, triggering taxable capital gains. Finally, the added trading and administrative costs drive up the fund's expenses.

So how pervasive are these abuses?

It's too early to tell for sure, but all the signs are that it's not confined to a few bad apples. "It is beginning to appear as though the entire crate is rotten," Spitzer told a congressional hearing in early November. Indeed, in the same hearings, SEC enforcement director Stephen Cutler said that a recent survey showed that half of the nation's 88 largest mutual fund companies had allowed selected customers to engage in market timing of their mutual funds.

How much is improper trading costing investors?

According to Stanford University business professor Eric Zitzewitz, market timing costs long-term shareholders $5 billion a year, and late trading costs $400 million per year. Those losses may add up to 1% or less in lost returns in a given year, he says. That equates to about $10 for each $1,000 invested in a fund.

Is that the biggest problem?

No. Try the $70 billion issue. That's how much investors are paying in mutual fund fees every year. Fees, of course, are a legitimate part of doing business. But as mutual fund assets swelled over the past two decades, fund companies enjoyed big expense reductions thanks to the enormous economies of scale that exist in the industry. The problem is, those cost savings haven't been passed on to investors--fees have actually increased over the past 20 years.

Should I dump a fund from a firm that's been implicated?

Morningstar, the Chicago fund tracker, recommends that investors "consider selling" funds run by some of the companies that have been singled out by regulators. "Investors should be alarmed and disgusted by some of the stuff that's gone on," says Don Phillips, Morningstar's managing director. At a minimum, Morningstar recommends scaling back your investment if you have more than half your assets with one of the firms involved.

What's the downside to selling a tainted fund?

With the scandal still unfolding, there's still a risk that you could buy a fund that's about to get swept up in the investigation. Also, assuming you hold shares in a taxable account, you could owe capital gains if you sell at a profit. Finally, since some funds impose back-end sales charges, selling could trigger redemption fees. Some funds charge 2% on money that's withdrawn. That's $20 for each $1,000 invested.

Will I get my money back?

Most of the firms implicated in the scandal have said they'll make restitution to shareholders. But Morningstar's Russ Kinnel says they haven't clarified whether they'll make payments to current shareholders or those who invested at the time the improper activities occurred.

Will I get hurt staying in a fund that investors are fleeing?

You could. When lots of investors are pulling their money out, expenses can grow because the fund has fixed costs and must spread them across a smaller asset base. Also, if redemptions are particularly steep, a fund manager could be forced to sell some of his holdings. If he sells at a profit, that means higher taxable capital gains distributions for you. So far, the effect of the probes has been negligible on the industry overall. But Putnam, Janus, and Strong have been suffering outflows lately. The bulk of the withdrawals have occurred at Putnam, where investors pulled $4.4 billion in the week ending Nov. 5, according to AMG Data Services. Putnam did not return calls seeking comment.

What happens if a fund company goes out of business?

Your money should be safe, says Morningstar senior analyst Gregg Wolper. The companies don't own the funds; they are just advisors hired by the fund's board of directors. So if your fund company goes out of business, the board will have to find a new company to act as the advisor. That doesn't mean there won't be a run on the fund's shares beforehand.

Finally, how long has this stuff been going on? And where was the SEC?

Industry experts say that market timing of mutual fund shares is hardly a new phenomenon. And the SEC's failure to lead the way in uncovering recent scandals has led to widespread criticism of the commission. The SEC does perform detailed inspections of mutual fund firms every three years or so, about 90% of which result in the issuance of "deficiency letters," which outline ethical violations ranging from minor to extremely serious. But fund management doesn't have to disclose the contents of the deficiency letters either to fund shareholders or to its own board of directors. "Ninety-five percent of what managers are doing wrong never is made public," says Edward Siedle, a former attorney for the SEC who now investigates abuses at money-management firms for pension funds. If they were, he adds, they would be guaranteed to scare off a lot of investors.

Siedle shared with FORTUNE the contents of a 1998 deficiency letter issued by the SEC to a firm that was later purchased by one of the country's largest mutual funds. The letter contains details of more than two dozen occasions when a senior executive bought and sold individual stock positions in his personal account before trading the same stocks for his clients--a highly unethical (and in many circumstances illegal) kind of trading known as front-running. In some cases, for instance, the executive was selling the same stocks he was buying for his clients. "It appears that [Mr. X's] interests were placed ahead of client interests on many occasions," the SEC states in the letter. The letter goes on to note that in its 1995 examination of the firm, the SEC had "previously cited [Mr. X] for personal trading irregularities and violating Registrant's trading policies." This type of illicit behavior, unfortunately, has a long history of going unpunished.