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."

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