Mutual funds reeling from questioned trade practices

The once rock-solid reputation of mutual funds has been tarnished in recent months after charges of questionable trading practices have come to light.

Last summer, New York Attorney General Elliot Spitzer charged that some mutual funds were engaging in two dubious practices–one of them illegal–and announced a probe to determine how far these practices extended in the industry.

Since then, new revelations have been coming out almost weekly. The most recent came Jan. 15 when Denver-based Invesco Funds Group — an $18 billion mutual funds company — said it would seek settlement with regulators over accusations of questionable mutual funds trading.

Ninety-five million Americans are currently invested in mutual funds. With an estimated $7.2 trillion invested in the funds, many investors are wondering whether they are still the relatively safe investment harbor they once were.

Losing investor trust

“I don’t know about anybody being scared,´ said Tom Hisey, a certified financial planner in Fort Collins with Linsco Private Ledger. “I think it’s more, ?I’m leaving these guys because they are not in my interest.’ A lot of them have just lost the trust of people. It’s really going to hurt a lot of them — the Putnams and the Januses and all the ones who have been accused of these issues.”

Banks are large sellers of mutual funds. Mary Beth Rogers, a spokeswoman for Bank One in Phoenix, Ariz., said she doesn’t yet know what will emerge from the ongoing controversy.

“I would point out that the (stock) market is up right now,” Rogers said. “In the course of an investor’s lifetime, the course of world events is going to influence everyone’s investment more than this.

“It’s far too early to tell what kind of impact it will have right now,” she said. “I don’t want to be blas? about it, but what a customer needs to do is to review their personal situation, years to retirement, investment goals and risk tolerance before making a decision.”

Even people who don’t believe they have much of an input in their 401k plan have more power in picking what’s in there than they might think, Rogers noted.

“All 401(k)s are self-directed,” she said. “That means it is up to the employee to determine what it’s made up of. You can self-direct any alternatives.”

Better monitoring needed

While mutual funds are a foundation of the stock market, there are aspects of investing in them that should be closely monitored, Hisey noted.

“There are (mutual) funds out there that are charging too much to manage your money,” he said. “There is an allowed overabundance of mutual fund market timers and the worst funds allow people to buy after the 4 o’clock close and that is illegal. Anyone caught doing that — you don’t want your money there.”

SEC investigators are reviewing two practices. One is after-hours trading, which occurs after 4 p.m. Eastern Time when the stock market closes for the day. While the closing price determines the starting price for the next trading day on the U.S. stock market, other exchanges around the world operate after the close and some traders try to take advantage of that fact by placing orders after the market closes.

The other practice — market timing — is not illegal but is regarded as unethical. Market timing includes the practice of allowing some people to get in more trades over a certain time period than others. It also includes the practice of trading in and out of funds in order to take advantage of any discrepancy between the fund’s share price and the value of its holdings.

Fair value pricing

Timothy Jares, assistant professor of finance at the Kenneth W. Monfort College of Business at the University of Northern Colorado in Greeley, wants to remove any temptation toward after-hours trading and market timing by introducing something called ?fair value pricing.’

“You have all these time-zone faults,” Jares said. “Mutual funds should not be using this old information.”

Jares advocates instituting a system in which a stock exchange like the NYSE closes at a certain price but when it reopens it does so at the price the stock was after it was traded at other exchanges.

“Basically, what drives the market timers are these stale prices,” Jares said. “They act on information that’s typically 12 to 14 hours old. They can know more about a stock in that time. The idea (behind fair-value pricing) is to remove the temptation.”

No one knows what changes may be in store for mutual funds when all is said and done. “We’re treading new ground here,” Jares said. “It could be anything. You could have a reaction from the market. I’m not aware of anything like this.”

The SEC is currently investigating more than 88 mutual funds across the country to see what their policies and practices are regarding market timing and late trading. SEC spokesman John Nester said penalties in the past usually involved repayment to shareholders, the surrender of any ill-gotten gains and punitive fines. The $250,000 fine the SEC levied against Alliance Capital Management Holding LLC in mid-December is the largest of its kind. Any jail time incurred because of this scandal is up to the Justice Department or the attorneys general of the states and not the SEC, Nester said.

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