Now Mutual Funds?

Investors still stinging from last year's run of Wall Street and CEO lies now find they can't trust mutual funds either. Turns out the $6.9 trillion fund industry might be just as willing to jilt the little guy when monster fees are on the line. This revelation is a black eye for a business that so far has been largely scandal free.

The problems came to light last week when New York attorney general Eliot Spitzer, who has made a career out of reading Wall Street's dirty email, asserted that "dozens" of "very substantial" fund companies are tolerating practices that rob everyday investors of more than $4 billion a year. Spitzer blew open the lid on bogus stock research last year after uncovering e-mail showing that some analysts didn't believe their own advice. Now he's nailing fund executives who in their email gave the O.K. for special treatment in return for large fees.

The behavior is "outlandish and criminal," Spitzer told TIME. "You go to jail for it."

His allegations center on one hedge fund, Canary Capital Partners, and its relationships with mutual-fund companies, including Bank of America's Nation's Funds, Banc One, Janus and Strong. Spitzer says the trail could lead to hundreds of mutual-fund companies. The Securities and Exchange Commission is investigating. The Investment Company Institute pledges full support of the probe.

At issue are two practices: late trading, which is plainly illegal, and market timing, a legal gray area that clearly harms shareholders. In late trading, a client buys or sells a fund late at night at the 4 p.m. price to take advantage of news that has broken in between. In market timing, a client trades a fund frequently, which many fund firms say they do not allow. Doing so drives up costs and hurts performance by forcing managers to hold more cash than they would like or to sell stocks they would rather hold. These costs are borne by all shareholders. "This has the impact of someone picking your pocket," says Mercer Bullard, securities-law professor at the University of Mississippi.

What can you do? Look for funds with written restrictions and penalties that discourage frequent trading of international funds (which give cheaters the most opportunity). Also look for "fair-value pricing," under which firms like Vanguard and Fidelity reset fund prices as news dictates. Consider exchange-traded funds, which are continuously priced and trade like stocks. In general, stick to funds with shareholder-friendly cultures noted by low expenses, a record of closing popular funds to new investors, restraint in offering new funds for every fad and managers with their own money invested in the fund.

Questions? You can e-mail Dan at danielkadlec@aol.com