A federal scolding for mutual funds

Washington has the mutual-fund industry in its sights.

Two years ago it was Enron and the arcane world of energy trading that led to congressional outrage and a spate of new legal controls. Today, it's alleged malfeasance on the part of brokers and mutual-fund management that has roiled Capitol Hill and drawn legislators into heated discussion about market timing, board governance, and other matters of business with which they are not normally concerned.

Will the outrage lead to forced changes in the way a giant industry operates? Maybe - though some legislators just want the Securities and Exchange Commission to toughen its enforcement act.

But if nothing else, the still-unfolding fund scandal may be more fuel for the renewed surge in populist, antitycoon rhetoric in some corners of the nation's capital.

In an era when the "perp walk" of a CEO in handcuffs is becoming more commonplace, there's political gain to be had in at least voicing support for the little guy.

"The mutual-fund industry is now the world's largest skimming operation, a $7 trillion trough from which fund managers, brokers, and other insiders are steadily siphoning off an excessive slice of the nation's household, college, and retirement savings," said Sen. Peter Fitzgerald (R) of Illinois, chairman of a Senate Government Affairs subcommittee, at a hearing Monday.

To date the alleged wrongs of the industry have been uncovered mostly by state, not federal, officials. New York Attorney General Eliot Spitzer has even complained that the SEC has been "asleep at the switch" in regards to mutual-fund oversight - although he softened that tone in an appearance before senators Monday.

The SEC did not begin an extensive mutual-fund probe until about two months ago. Since then it has sent subpoenas to dozens of firms, including Fidelity Investments, Janus, Morgan Stanley, and Vanguard. There is now a "massive" SEC field force pursuing allegations of mutual-fund wrongdoing, chairman William Donaldson said in a Monday appearance at the University of Connecticut.

"I don't think it is very constructive to take potshots at the SEC," he said.

Congress swung into action this week, with extensive hearings in both the Senate and the House. At issue from the congressional point of view are two alleged trading abuses: market timing and late trading.

Under market timing, investors typically buy and sell mutual-fund shares quickly in an attempt to profit from disparities between the share price and the value of the mutual fund's underlying securities. While not illegal, strictly speaking, it is supposed to be discouraged by fund management as it siphons money out at the expense of other shareholders.

Late trading is more self-explanatory: It occurs when investors are allowed to place orders to buy or sell after the 4 p.m. close. Unlike market timing, it is illegal.

Half of the largest mutual-fund companies allowed select customers to engage in market timing, said Stephen Cutler, director of the enforcement division of the SEC, at a House hearing Tuesday.

One-fourth of them helped customers in potentially illegal late trades, Mr. Cutler added.

"We will aggressively pursue those who have violated the law and injured investors as a result of illegal late trading, market timing, self-dealing, or any other illegal activity we uncover," Cutler concluded.

The scandal is of great interest to lawmakers because of the obvious: the vast number of voters who own mutual-fund shares and might be affected.

Mutual funds are the main investment vehicle for all but the most sophisticated of stock owners. Half of the nation's households own mutual-fund shares.

But it's not clear how much Congress can do about the situation, other than urge the SEC and other regulator cops to more intensive effort.

In the House, Rep. Richard Baker (R) of Louisiana, a member of the Financial Services Committee, has introduced a bill that would require fuller disclosure of trading arrangements by funds, and end what he terms serious conflicts of interest among top executives.

In the Senate, Senator Fitzgerald of the Governmental Affairs Committee, among others, has urged measures to make mutual-fund directors more responsive to investor interests.

There are already some suggestions on ways to try to limit after-hours trading. On Monday, the Investment Company Institute (ICI) proposed a 4 p.m. deadline on all mutual-fund trades. John Bogle, the former chairman of Vanguard Funds, has suggested a 2:30 p.m. closing time for investors.

"But this will limit the ability of the average investor to make decisions at the end of the day. It will make mutual funds less attractive," says Bob Knuts, a partner in New York at the law firm Day, Berry & Howard and a former SEC senior trial counsel.

For most investors, a change in trading hours would probably not make much difference. But there are some people who actively trade stocks. They believe they can "time the market" - that is, buying individual sectors just when they become hot. Although market timing is not illegal, it may disrupt the funds themselves, says Mr. Knuts. "It depends on how much is moved in and out and how much impact it has on the fund," he says.

The funds themselves are somewhat resistant to change because they are now facing greater competition. In recent years, new investment vehicles, such as "exchange traded" funds have sprung up. These are actual baskets of securities that act like mutual funds but are traded on an exchange. They have great flexibility. "Anything that restricts mutual funds will make other alternatives look better," says Knuts.

On the regulatory front, Knuts doubts Congress will act to beef up the SEC because it already did that a few years ago with the goal of making it possible for the regulators to reduce the time between inspections of mutual funds. In the past, the SEC inspected a fund once every five years.