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Revelations that several mutual fund managers engaged in illegal trading to benefit big investors have tarnished the industry and will likely shake confidence in the implicated companies, experts said. But as long as stock prices keep rising, middle-class Americans are unlikely to veer away from mutual funds.

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On Wednesday, New York State Attorney General Eliot Spitzer announced a $40 million settlement with New Jersey hedge fund Canary Capital Partners over allegations it engaged in illegal trading in mutual fund shares sold by some Wall Street firms and banks, including Bank of America’s Nations Funds, Bank One, Janus Capital Group and Strong Capital Management.

Spitzer accused the fund companies of engaging in fraudulent after-market trading activity that may have cost individual investors billions of dollars.

The question now is whether the charges and continuing investigation of the mutual fund industry will significantly hurt investor confidence.

“I think this fraud was more outrageous than Enron,” said Steve Thel, a securities law professor at Fordham University in New York. “It’s a complicated plot, and people don’t see it’s a nickel from a million people. It’s a violation of the law that was premeditated and deals with our retirement money and it’s truly outrageous.”

“I can’t see how this can’t shake investor confidence,” said Kunal Kapoor, associate director of fund analysis at Morningstar. “The whole idea of the mutual fund industry is to give the smaller investor a level playing field with large investors so there’s no preferential treatment, but this really violates that.”

Muted reaction on Wall Street
Judging by the performance of stocks Wednesday and Thursday, Wall Street has been unmoved by news of the investigation.

The muted reaction may have had more to do with a lack of understanding among individual investors about the seriousness of the crime, hypothesized Thel.

Shares of the fund families named in Spitzer’s complaint have come under pressure in recent sessions, and they may fall further in the near term if worried investors decide to withdraw their funds, said Phil Edwards, managing director for mutual fund research at Standard & Poor’s.

“I would think the firms mentioned may suffer a loss of assets, and depending on how high that is it might have an impact for existing investors,” Edwards said. “But a run on the bank is not a high probability. Most of these funds are deep and rich, so a loss of assets will not have a huge impact on them.”

In addition to the four fund families named by Spitzer, Prudential Securities also is reportedly the target of a similar investigation by Massachusetts’ top securities regulator.

Still, Edwards doesn’t see a lasting impact.

As long as stock prices keep rising, investors are likely to continue to commit funds to equities, he said. Recent data from TrimTabs.com, a mutual fund research firm, show stock funds took in some $8 billion in August, as Wall Street’s rally, which started in mid-March, continued.

“Investors tend to follow the performance of the stock market,” said Edwards. “So while we might see some habituation, I don’t think this issue will have a long-term impact on mutual fund investments. There are lots of other mutual fund groups out there, and funds are still the most efficient way to create a diversified portfolio. So people will continue to invest in mutual funds, even if they decide not to give their money to Janus.”

Reliability of industry diluted
A less tangible but still potentially damaging impact could come from a loss of face. Although Wednesday’s announcement is not the first instance of wrongdoing in the mutual fund business, after touting itself as squeaky-clean in the wake of the Wall Street scandals of 2002, the reliability of the fund business is now in tatters, observers say.

“We seem to yield frauds every few years in the securities industry, but the mutual fund business has remained above all this for the 63 years that it has been regulated. Now that’s changed,” said Mercer Bullard, president of Fund Democracy, an advocacy group for fund shareholders and a securities law professor at the University of Mississippi.

Investors should yank their money out of the fund families involved in Spitzer’s complaint, said Bullard.

“This is going to cost Bank of America a lot of business, and if I held stock in the companies involved I’d be selling them,” he said. “This is going to cost the industry net assets, and it’s the just the beginning of an ongoing exploration into these funds.”

One area of the fund business likely to be affected is international funds, Bullard said.

In his complaint Wednesday, Spitzer identified an illegal practice called late trading, in which preferred investors were allowed to buy fund shares at the 4 p.m. ET close of trading in New York, even though other investors can receive that price only if they buy before the close. The preferred investors, or market timers, often target international funds, where they benefit from large pricing gaps created by time differences.

“I expect this to have a negative impact on any international funds,” Bullard noted. “Whether or not these funds offer accurate pricing, they will be tainted by the scandal.”

If widespread fraud is discovered in the mutual fund industry, investors have every reason to take their money out of the financial institutions that are implicated, or at least make sure the companies they invest with are moving swiftly to deal with it, said Morningstar’s Kapoor.

Investors can also ask funds to adopt a practice called “fair value pricing,” a practice that wards against market timers by adjusting a fund’s closing price to reflect any major events after the close of trading, Kapoor added.

Fund investors can also ask that a fund’s board members are compensated with shares in the fund and not cash, aligning their interests with those of the fund holders.

“For most individual investors, investing in mutual funds still makes sense, but they need to be careful about where they invest their money,” Kapoor said. “They need to be ahead of the game.”

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