Quotes of the Day

On a Saturday morning four weeks ago, New York State attorney general Eliot Spitzer walked onto a tennis court in Washington for a match with his niece and chanced upon Matthew Fink, president of the Investment Company Institute, the mutual fund industry's trade group. Howya doing? Spitzer asked. Fine, Fink answered. He then mentioned that his industry seemed to be under unusual scrutiny, adding, "At least you aren't giving us a hard time." Spitzer's response left Fink weak in the knees. "Just wait," he said with a smile.

Fink didn't have to wait long. On Sept. 3, the crusading A.G., fresh from lashing the brokerage industry into a $1.4 billion settlement over fraudulent stock research, revealed his latest target: the mutual fund business. This time Spitzer asserts that the industry we have trusted to put us on equal footing with the big hitters was favoring them at our expense — through short-term trading schemes that dilute the gains of long-term holders.

His investigation issued its first criminal charge last week and began to shift to a second set of mutual fund trades — those by Millennium Partners, a $4 billion hedge fund run by storied Wall Street investor Israel Englander. And Spitzer wasn't the only cop on the Wall Street beat. The NASD, a securities-industry regulator, had settled a separate case with Morgan Stanley, which it charged with offering brokers improper incentives to push in-house funds that might not be best for its clients.

The fallout from Spitzer's assault has been swift. Fund-research firm Morningstar — the 800-lb. gorilla of independent fund analysis — took the unprecedented step of warning investors to avoid the four fund families at the eye of Spitzer's storm — Strong, Bank of America's Nations Funds, Bank One's One Group, and most Janus offerings (except for its Mid Cap Value, Small Cap Value and Risk-Managed Stock funds, which are run by outside managers). "The firms put their own profitability ahead of shareholders'," says Kunal Kapoor, Morningstar's associate director of fund research. "Until we see changes, we don't think they deserve to be trusted with people's money." A riled-up Janus shot back that Morningstar was acting with "recklessness and irresponsibility." The company said it has pledged to cooperate with Spitzer and even put back money after it determines which funds were hurt and by how much.

The fund industry, its trust breached, is now making all the right noises. Fink called the alleged abuses "outrageous" and urged all his group's members to review their internal procedures. Spitzer's investigation is far from over, though, and it may touch broadly an industry entrusted with $7 trillion of our retirement and other savings — a gargantuan sum that politicians will be eager to make a show of protecting.

Spitzer's investigation, which like his stock-research probe has been based in large part on incriminating corporate e-mail, will almost certainly lead to additional inquiries about fund fees and the roles of fund directors. It may also lead to efforts to corral the largely unregulated and fast-growing hedge-fund world, which has $600 billion in assets. It's the hedge funds, investment vehicles available mainly to the wealthy, that sometimes roil markets with rapid trades of stocks, bonds and currencies and that appear to be the main clients that have traded mutual fund shares in a way that is harmful to most mutual fund investors. For years, Congress and the Securities and Exchange Commission (SEC) have talked about improving oversight of hedge funds and the industry in general. But not much was done — until Spitzer started paying attention. "It's been a wake-up call to Congress," says Burt Greenwald, a mutual fund — industry consultant.

At the heart of the Spitzer probe are two practices that, by some estimates, collectively bilk fund investors out of as much as $4 billion a year. One is late trading, which is illegal. Spitzer brought grand-larceny and securities-fraud charges against Theodore Sihpol III, a former broker at Bank of America, alleging that Sihpol helped Canary Partners, a hedge fund, place orders to buy and sell Nations Funds shares as late as 6:30 p.m. at the funds' 4 p.m. (closing) price. The scheme allowed Canary, which has settled its case with Spitzer for $40 million, to profit from intervening news. (Many big corporate announcements are made just after the close of the trading day.) Sihpol's attorney says his client had supervisor approval for his actions.

The second practice is market timing, with investors trading in and out of a fund on a daily basis. That practice is legal, but large fund companies generally discourage it. For buy-and-hold outfits such as Fidelity Investments and Vanguard Group, market timers drive up transaction costs, which are borne by all shareholders. Plus, the rapid movement of money makes a fund difficult to manage, possibly hurting long-term returns. In international funds, market timers may be able to take advantage of "stale" prices — trading a fund in the U.S. when the price may not yet reflect movement in foreign markets. From a legal standpoint, market timing is an issue only for funds that officially ban it but make allowances for hedge funds and others who pay them big fees. Market-timing violations are far more widespread than late trading. The cases against Janus, Strong and Bank One are limited to market timing, which academic studies show can raise costs as much as 2% of a fund's assets each year — a detriment to long-term holders.

Sources familiar with Spitzer's investigation say the next company on the grill is likely to be the private Millennium hedge funds run by Englander. These funds racked up big gains in the recent bear market, according to Institutional Investor, rising 10%, 16% and 36% in the past three years — when the value of the average stock and stock mutual fund declined. Sources tell TIME that Spitzer is looking at possible late trades and market timing by Millennium, though it is not clear which mutual funds and which brokers Millennium was dealing with. Through a spokesman, Englander, who is prominent in New York City charity circles and owns several specialist firms on the floor of the American Stock Exchange, declined to comment.

Spitzer says the mutual fund industry got on his radar through its own hubris. He first took notice a year ago, when the SEC (then under embattled chairman Harvey Pitt) was pushing the industry to disclose how fund managers vote their shares when corporations elect directors and decide other issues, such as takeovers. The fund industry resisted, saying, in part, that such disclosure would be expensive. "That's malarkey — put it up on your website," Spitzer recalls telling them. "I thought these guys were completely arrogant." By resisting calls for disclosure, Spitzer adds, "it should have been apparent to them that it would raise questions to people like me." He was further piqued by what he felt was the abrasive tone of some fund executives at a panel discussion at Harvard Law School last June, when he concluded that "they just don't get it." Shortly after that, he got a critical tip — he would not elaborate — leading him to the questionable trading practices at Canary and the four mutual fund companies.

Many in the fund business say they are annoyed that Spitzer has characterized the abusive trading practices as widespread — without providing further evidence. Yet only a few, among them Vanguard, Fidelity and T. Rowe Price, have come out with strongly worded assurances to investors that they are doing everything possible to avoid the problems. "We didn't even wonder if someone was doing that here," says Jack Brennan, chairman and CEO of Vanguard. "We have a lot of defenses to avoid that possibility, but most importantly, it's the ethic of the firm." Spitzer defends his investigation and his decision to take it public, saying he cannot name other names until he has built a case. Moreover, he says, by spouting off early "we probably have stopped a lot of it."

Eradicating the abuses will be difficult. Fund companies have less control over the trading of their fund shares than one might imagine. Most fund shares are traded through third-party brokers who don't report activity to the fund companies until well after the close of trading — after they have tallied the full day's activity and netted out buys and sells. "The challenge," says Edward C. (Ned) Johnson III, chairman and CEO of Fidelity, "is to reduce the opportunity for wrongdoing." Johnson suggests two steps: first, assign fiduciary responsibility to any company that has any part in executing a mutual fund trade, so if shareholders' best interests are not served, penalties will follow; second, create a central clearinghouse for all fund orders, thus ensuring that trades are executed at the correct price.

What should investors do in the meantime? "Stay the course," advises Spitzer, whose own family fortune rests in real estate. "The marginal cost to any one shareholder is slim." In the end, says Morningstar's Kapoor, you should invest in a fund company you trust. Find one, he says, that emphasizes "stewardship over salesmanship," that puts long-term shareholders first by keeping expenses low, that closes small-cap funds once they get large and that refuses to roll out gimmicky funds in hot sectors.

"I just hope this doesn't sour fund investors," say Sheldon Jacobs, editor of the newsletter No-Load Fund Investor. "Whatever the problems, mutual funds are still better than almost any alternative. If you think mutual funds lack integrity, try dealing with brokers, insurance agents, annuities salesmen or hedge funds." In other words, this black eye will heal, and maybe now industry executives, as Spitzer might say, will finally get it.

• Daniel Kadlec