Are They All Crooked?

By Jyoti Thottam

Steven Romick is one of the good guys. He runs a small mutual fund in Los Angeles, FPA Crescent, that prides itself on investing for the long haul. He keeps most of his own money in the Crescent fund, hasn't taken any out since he bought his house seven years ago and turns away would-be market timers at the door. There's no ethical cloud hanging over Romick's fund, but he suspects some people are too scared of funds like his to give it a try. He shakes his head with a disgusted sigh. "Individual investors are starting to feel like the game is rigged," he says.

Who can blame them? Mutual-fund managers have suddenly joined the long parade of suits in handcuffs that began with Enron two years ago and has led to monster fines, complex trials and a video of at least one multimillion-dollar toga party. It was bad enough when mutual-fund returns were pummeled by a two-year-long bear market that started to thaw only this spring. Then, in September, a few funds came under fire from New York State attorney general Eliot Spitzer for allowing big, sophisticated investors to game the system. The abuses are turning out to be so prevalent that regulatory officials predict a big shake-out. "There are going to be criminal cases brought in considerable number down the road," Spitzer told TIME. "It's not one or two bad apples. The whole crate seems to have gone rotten."

The depth of the scandal started to become clear with the alarming testimony of Stephen Cutler, enforcement director of the Securities and Exchange Commission, who spoke at hearings before the Senate last week. The SEC has so far examined records from 88 of the largest mutual funds in the country, looking for evidence of market timing--rapid, short-term trading that most mutual funds try to discourage because it drives up costs for other investors--and late trading, the illegal practice of allowing investors to trade after hours using outdated prices.

In its preliminary review, the agency found that 50% of the funds had made special arrangements for market timing, 30% helped market timers cover their tracks, 10% reported possible late-trading situations and three funds actually approved late trading. The scandal has so far implicated 11 prominent funds and 10 fund executives and brokers. Putnam Investments, a Boston firm embroiled in the scandal, lost $8.4 billion in assets pulled out since Oct. 29 by spooked investors and state pension funds. "We are disappointed by their decision and hope that we'll be able to manage their funds in the future," a Putnam spokeswoman says. The company has replaced its management and promised to reimburse losses to the fund.

Cutler also said that more than 30% of the funds surveyed appeared to have disclosed details about their holdings only to select investors, who could have traded on that information. "It's insider trading. It's totally illegal," says Kathryn Barland, a senior research analyst at Lipper and a former SEC enforcement officer. "I suspect it's very common."

A couple of months ago, few expected to see the words "mutual funds" in a corporate-scandal headline. Even Spitzer, who spent most of last year wrestling with Wall Street's biggest investment banks, did not suspect that there was anything amiss in the funds industry until he began investigating it this summer. "Most people had accepted that the mutual-fund industry was reasonably free of these sorts of problems," he says. That reputation is partly what has driven mutual funds' tremendous growth since they were established in their current form in 1940 as a way for the average investor to play the market without taking on too much risk. Thanks in part to the rise of 401(k) plans, which added retirement savings to the pool, 54 million American households hold a combined $7 trillion in mutual-fund assets.

But mutual funds have outrun the regulations intended to keep them in check. Matthew Fink, president of the Investment Company Institute, a mutual-fund trade group, notes that in 1968, when the cutoff time for late trades was set at 4 p.m., there were 100 mutual funds and 300 intermediaries dealing in them. Today there are 8,800 funds and thousands more brokers, banks, 401(k) plans and trusts selling them. "The regulation has not caught up with the growth in the structure," Fink says. The poor returns of the recent bear market also created a new temptation for fund managers, who could boost the size of their assets (a key factor in determining their pay) by making deals with traders to park money in the fund in exchange for late-trading or market-timing privileges. In this environment, the only thing protecting the average investor is the integrity of fund managers.

How do you regulate that? For one thing, as with last year's corporate accounting scandals, boards of directors will get closer scrutiny. Congress is considering a bill that would tighten board oversight of mutual-fund managers and increase the number of independent directors, including the chairman. Spitzer says that an alert board of directors can easily detect market timing using public information about the fund's trading volume, and would never allow fund executives to trade their own funds against the interest of shareholders, as the chairman of Strong Funds is accused of doing. (Richard Strong has said he will reimburse the fund for any gains found to be improper.) But cleaning up the mutual-fund industry will take more than that. "I don't see this as a governance issue," says John Brennan, chairman of the Vanguard Group. "Half the named funds [in the scandal] had independent chairmen."

Don Phillips, managing director of Morningstar, the leading mutual-fund rating agency, says the rash of revelations about improper trading will force funds to be more transparent. "The fund industry is going to get the biggest scrubbing that it has ever gotten," Phillips says. Details about fund expenses, for example, could reveal whether market timing is inflating transaction costs. Academics estimate that late trading costs investors $400 million a year and market timing $4 billion to $5 billion. Aggressive fees for short-term trades would show that a fund is discouraging rapid trading, a signal of market timing.

Revealing such information may be required under expected new SEC regulations. "You're going to see a very tough enforcement program," says Barry Barbash, an attorney at Shearman & Sterling in Washington and former head of the SEC's division of investment management. But the agency is still trying to catch up to the new responsibilities piled onto it in the wake of last year's corporate scandals. Congress increased the SEC's budget by 47%, to $716 million, but $100 million of that went unspent in the past fiscal year because the agency was not able to hire staff fast enough. "The focus of the SEC has been redirected," says Representative Richard Baker of Louisiana, who proposed the mutual-fund legislation before Congress. "They're still not where we would like them to be."

In the meantime, investors can take heart. This corporate scandal is different--you can do something about it by becoming a smarter investor. Morningstar's Phillips says the public has a unique opportunity to reward firms that guard the interests of long-term investors. Some common-sense signals will identify the funds for you. Is the annual letter from the fund's chairman candid and straightforward? Does the fund tout short-term performance to draw new investors? Has it taken a clear stand against market timers? Where do the fund managers invest their own money, and are they willing to tell you? "Individuals need to step back and pay attention to the cost of what they're buying," says Vanguard's Brennan. Choose wisely--the future of the mutual-fund industry may depend on it. --With reporting by Barbara Kiviat/New York City and Eric Roston/Washington

With reporting by Barbara Kiviat/New York City and Eric Roston/Washington