Some think they are isolated cases; others say their faith is being tested.

With the mutual fund industry dodging so many bullets recently, even the most loyal mutual fund investor might not be blamed for raising an eyebrow.

Earlier this year, investors were digesting the revelation that many funds owned stock in Enron and WorldCom even as the accounting methods at those companies reached new creative heights. Fund expenses took center stage in March when Vanguard founder John Bogle noted a link between high fund costs and poor investment returns, in testimony before the U.S. House of Representatives. In April, fund manager Ronald Baron paid a $2.5 million fine to the Securities and Exchange Commission on charges that he had manipulated shares of Southern Union. Questionable trading practices, such as "soft dollar trades" and commission costs buried in wide bid-ask spreads, also made their way into the news. So it was hardly a surprise to longtime mutual fund observers that the industry's chief lobbyist, Investment Company Institute President Matthew Fink, who had fought hard to stonewall the outcry for increased disclosure, resigned quietly this fall.

But it was an unexpected announcement by New York Attorney General Eliot Spitzer's office in early September that carried the topic of mutual fund regulation from the financial pages to network news. Spitzer and his staff had obtained evidence of illegal fund arbitrage and late trading by Canary Capital Partners. The charges against the hedge fund, which agreed to a $40 million settlement without admitting any wrongdoing, would probably have faded from public view fairly quickly had they not involved collusion by Canary with executives at fund firms Janus, Bank of America (NationsFunds), Bank One and Strong.

The investigation focused on allegations that the fund companies had worked with Canary on transactions involving late trading and market timing. Late trading, an illegal practice, involves purchasing mutual fund shares at the price set at 4 p.m. after the market closes. It allows short-term traders to take advantage of post-market closing events that could influence the fund's share price, such as an earnings announcement by a major holding. Market timing, in these cases, involves short-term trading of mutual fund shares-a practice fund companies say they discourage, but which is not illegal. Timing may work to the detriment of "buy and hold" investors because it can increase mutual fund expenses and force portfolio managers to hold more cash and sell securities at prices they wouldn't otherwise accept.

Reaction was swift. SEC Chairman William H. Donaldson called the conduct alleged in the complaint "reprehensible," and vowed further investigation. Morningstar analyst Brian Portnoy recommended that investors avoid Janus, Strong and Bank of America funds, despite the firms' pledge of full restitution to harmed shareholders. In late September, Alliance Capital Management suspended two employees, one of them a fund manager, after an internal investigation revealed that they had engaged in market timing of the firm's funds. In early October, Prudential Securities forced the resignation of a dozen stockbrokers and managers suspected by the company of improper market timing.

Despite the controversy swirling around them, reaction from financial advisors, their clients and the investing public has been relatively muted. For some advisors, the jury is still out on the issue of whether late trading and market timing are common practices, or indiscretions committed by only a handful of firms. (For results of a recent study on this topic, see the box accompanying this story.) "I would prefer to think, in the absence of evidence to the contrary, that gross violations of the law represent isolated cases and are not ubiquitous in the fund industry," says David Yeske, principal at Yeske & Co. in San Francisco.

Yeske believes advisors need to keep the alleged incidents in perspective. "What overshadows these charges is the fact that mutual funds are a brilliant device for investors to achieve economies of scale and are superb building blocks for a diversified portfolio. It is way too early to generalize across the entire fund industry. We don't want to throw the baby out with the bath water." He has no plans to sell his "modest" position in the Strong Ultra Short Bond Fund simply because another fund in that family is under investigation.

Elizabeth Jetton, principal of Financial Vision Advisors in Atlanta, says that while she is "disappointed" by recent headlines, she calls Morningstar's reaction "premature, and more punitive than anything else. It's a mistake to make broad, sweeping pronouncements without knowing the extent of the problem or what the consequences are for individual investors." While she has some client money in the fund families named in the Spitzer investigation, she sees no reason to sell them at this point.

Greg Sullivan, CEO of Sullivan, Bruyette, Speros & Blayney in McLean, Va., says that despite his decision to sell a small position in one fund under investigation, he hasn't lost confidence in the industry as a whole. "We've been in touch with several fund managers, and they've assured us that the issues being reported in the press are not affecting us," he says. "There is no evidence to suggest that these are anything but isolated cases. As a mutual fund owner, and as an advisor, I am not worried."

Neither, apparently, are the majority of investors, who may be suffering from scandal fatigue. "We have not seen lot of consumer interest in the topic of fund scandals," says Heather Almand, director of public relations for FPA. "I don't think we've gotten a single inquiry about it on our consumer hotline." When the association queried members about the fund scandals on its Web site discussion board, she says, "There was no energy around the topic."

Clients, for the most part, also appear uninterested. Jetton reports that she has received no phone calls regarding any of the fund scandals, while Sullivan says he has fielded queries from "a couple" of individuals. The fact that stock funds took in some $3 billion during the week ending September 17, less than two weeks after news of the investigation broke, validates the observation by advisors that individual investors generally do not believe that what they are hearing about in the news has any impact on their own portfolios.

Reasons For Concern

But some advisors see that viewpoint as wishful thinking, and believe recently reported incidents reflect a deeper industry malaise. Steve Kanaly, president of Kanaly Trust Co. in Houston, says that many professionals don't realize the magnitude of governance problems funds have, or how those problems might affect them in the future. "We need to get a handle on an industry that has clearly gotten out of hand," he says.

A lack of independent oversight tops Kanaly's list of concerns. "Mutual funds are pretty much a self-regulated group," he says. "All too often, the board of directors consists of people who rubber-stamp what the fund company wants, and fail to consider the best interest of shareholders. They (the fund companies) have forgotten who they are working for." Kanaly believes that because of its tight budget and limited resources, the SEC is not giving funds the kind of oversight they need. "The mutual fund industry has grown much more rapidly than the regulators who are supposed to be watching it," he says.

Some advisors fear that if stiff penalties are not imposed on the fund executives who violated laws, more such behavior is likely to follow. "It's a total betrayal of confidence," declares Bill Bengen of Bengen Financial in El Cajon, Calif. "These guys have to be brought to justice. Until recently the mutual industry has stood out as an exception to all the problems and scandals on Wall Street."

But Bengen himself never used Strong or Janus funds for clients. "I always thought they were a little too aggressive, taking big risks in the name of performance," he explains.

The blasé attitude of some advisors also worries Richard Wagner of WorthLiving LLC in Denver. "Financial advisors have to be careful about who they do business with," he says. "To a large degree, the financial services business is based on trust. The accountants blew Enron and look what happened to them. Where are we on Strong and Janus?" Two years ago, Wagner authored an article in Financial Advisor proposing that investment companies who do business with advisors appoint at least one advisor to their board of directors. Given the questionable oversight of many funds' boards, such an idea could potentially address that problem.

Others agree with the need for more shareholder-responsive governance. "Most mutual fund boards are made up of 'yes' men who do not properly oversee the funds they are paid to oversee," observes Scott Dauenhauer, a principal of Meridian Wealth Management in Laguna Hills, Calif. "Most mutual fund companies focus on short-term rather than long-term performance. They are more interested in pleasing advisors, who control distribution, than the end user." He believes that while mutual fund after-hours trading is probably an isolated incident, it exemplifies "a greater problem in the mutual fund industry-the fund company and the boards putting the fund company's interests above and beyond the interests of the investor."

The bottom line for advisors, says Kanaly, is their responsibility as client fiduciaries. "Advisors are such a fragmented, busy group that it is often difficult for them to think things through and react," he says. "But I think the courts will react if they feel advisors should be held more accountable as fiduciaries. That makes it critical to reconcile whether mutual funds are adhering to certain guidelines."

While the possibility that an advisor could face legal action because of a fund's governance practices may seem remote, it is not impossible. In a worst-case scenario, a financial advisor could face a lawsuit from a client who lost money in a mutual fund with a record of severe and repeated violations, says Mercer Bullard, a securities law professor at the University of Mississippi School of Law and a former SEC Assistant Chief Counsel. "If an advisor had reason to know that a fund has a demonstrated history of compliance problems, then legal action would not be inconceivable," he says. "I think the bigger question is why anyone should risk that kind of liability when there are so many fund alternatives out there."

Apparently, some corporate retirement plan administrators agree that enough liability risk exists to justify an exit from funds under the microscope. Scott Brewster of Brewster Financial Planning in Brooklyn, N.Y., reports that one of his clients who had the Janus Overseas Fund in a company retirement plan was forced by her company to sell the fund and put the proceeds into cash. Her only other international investment option is a fund with a 5.75% front-end load and high annual fees. "The whole situation stinks," he says. "It seems the mutual fund companies win no matter what they do, at the expense of our clients."

Brewster, who relies mainly on index funds, says the scandals provide additional fodder for arguments in favor of passive investment management. "Scandals like these are reason enough to avoid actively managed mutual funds and invest solely in index funds," he says. "Passive index investing allows you to avoid the risk of rogue managers and general improprieties. Index funds are far more transparent, and their goals are clearly defined."

Financial advisors who favor actively managed funds still see room for improvement in key issues such as disclosure. "Prospectuses are still unfriendly and should be simplified," says Jetton. "Reading one is something like trying to climb a mountain without trail markers."

The frustrating thing for many advisors is that, even though mutual funds are transparent when compared with hedge funds and other types of investments, costs generated by after-hours trading and soft dollar deals can easily elude detection. Unlike sales charges and investment management fees, which require clear disclosure in prospectuses and other fund documents, such stealth practices can be quietly buried, yet potentially costly. And the worst may not be over if the SEC ignites new controversy by uncovering damaging information about how much those practices cost investors.

Despite such concerns and the recent spate of scandalous headlines, many financial advisors continue to believe that the policies in place at most fund companies protect the interests of shareholders. Without that belief, they would need to re-examine the very core of their investment philosophies, and the basis of their businesses. The question now is whether the industry that has provided the products they need to attain success will take the actions necessary to retain their trust-and the trust of their clients.

Common Practices Or Isolated Cases?

Despite the widely publicized fund scandals involving late trading and market timing, many financial advisors feel that such practices are limited to a minority of funds and represent isolated incidents. Recent research from Stanford University, however, points to a different conclusion.

Eric Zitzewitz, an assistant professor of strategic management at Stanford Graduate School of Business, examined a sample of data covering 10% to 15% of the mutual fund industry soon after the New York Attorney General office's announcement of its investigation into whether specific mutual funds had colluded with hedge funds to facilitate the illegal practice of late trading. Based on data from TrimTabs Investment Research, which tracks fund daily assets, returns and distributions, he estimates that the effects of late trading cost individual shareholders five basis points for international funds and 0.6 of a basis point for U.S. equity funds. He found evidence in the sample that late trading had occurred in the international funds of 15 out of 50 fund families, and in 12 of 96 domestic fund families. His agreement with TrimTabs prevents him from naming the families involved.

In earlier research, Zitzewitz studied market timing, a practice that is not illegal but one that can be costly to shareholders. "While the amount of long-term shareholder wealth lost due to late trading is large in absolute dollar terms, it is small relative to that lost to market timing," he concludes. "It is also probably smaller than the impact of excess trading due to incentives created by soft dollars, and smaller than the cost to investors of choosing high-expense-ratio index funds."