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When mutual funds cheat

The widening investigation into trading practices at some of the nation’s biggest mutual fund companies seems unlikely to trigger widespread outrage for several reasons, say experts.
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The widening investigation into trading practices at some of the nation’s biggest mutual fund companies has all the hallmarks of another big Wall Street scandal. Yet the allegations that four funds offered preferential — and sometimes illegal — treatment to a well-connected hedge fund have been met so far by a collective yawn on Main Street. Where is the outrage?

On the surface, the probe of mutual fund practices by federal and state regulators has the potential to be as damaging to investor confidence as last year’s disclosures of fraud and misdeeds at Enron, Arthur Andersen, WorldCom and other firms. After all, mutual funds are the investment vehicle of choice for tens of millions of small investors who rely on the industry’s reputation for integrity — virtually untainted by scandal until now. About 50 million of the nation’s 119 million households own stocks through mutual funds, compared with about 25 million households that own individual stocks.

But even though improper trading practices may have cost mutual fund shareholders billions of dollars, according to New York Attorney General Eliot Spitzer, many investors seem unaware of the investigation, much less concerned about it. A spot check of several mutual fund branch offices in northern New Jersey found little or no phone traffic asking about the probes, and only one affected company, Janus, has seen a significant decline in its stock price. While the investigations are growing, the scandal seems unlikely to trigger widespread outrage for several reasons, say experts in investor psychology.

First of all, the schemes outlined by Spitzer in an initial complaint and settlement were extremely complex, much harder to grasp than, say, the $11 billion in accounting fraud that sent telecommunications giant WorldCom into bankruptcy.

Spitzer charges that fund managers at Bank of America allowed Edward Stern and his Canary Capital Partners to profit through the illegal practice of late trading, which Spitzer likened to “betting today on yesterday’s horse races.” At least three other companies, according to the complaint, allowed Canary to engage in short-term trades to benefit from temporary price differences. The practice, known as market timing, generally is prohibited by fund policy because it is detrimental to rank-and file investors.

Second, while the practices may have enriched the wealthy, Stern with $30 million in illegal profits, which he has agreed to repay, the damages appear to have been spread out widely across a base of thousands of mutual fund investors.

“This is like a tax on the mutual fund holders,” said Terrance Odean, a professor at the Haas School of Business at the University of California in Berkeley. “It’s certainly scandalous, but no mutual fund owner can easily identify the cost to them. It’s not like owning Enron or WorldCom stock and watching it hit the toilet.”

In other words, it is the damage of a thousand cuts. Odean said the lack of reaction is completely consistent with research he has done showing that mutual fund investors have grown increasingly reluctant to pay high front-end “load” fees but have shown no aversion to funds with high annual operating expenses.

While mutual fund holders may have lost pennies a share or more to improper trading practices, that is a far cry from earlier scandals such as Enron, where thousands of innocent bystanders lost their jobs, their life savings or both.

“People just don’t seem to understand what’s going on” in the mutual fund case, said Lynn S. Paine, a professor at Harvard Business School. “In the cases like Enron and WorldCom, you have injuries which are highly visible and very acute. People see a very tight link between cause and painful effect, and it’s very easy to understand what happened in those cases.”

Paine, author of “Value Shift: Why Companies Must Merge Social and Financial Imperatives to Achieve Superior Performance,” said investors also view the latest scandal through the prism of the more cataclysmic events of last year and probably breathe a sigh of relief that the charges against mutual fund companies are not worse.

Last year’s wave of scandals was like a series of “earthquakes,” she said. “They shook the system to its foundation. These are more like aftershocks.”

Last year’s scandals also featured a colorful cast of free-spending characters that stoked investor anger, a feature so far lacking from the current drama. Just compare Stern, the little-known heir to a New Jersey pet-food fortune, with Enron’s Kenneth Lay, nicknamed “Kenny Boy” by President Bush, or Tyco’s Dennis Kozlowski and his $15,000 umbrella stand. Paine cautioned against the danger that investors will grow increasingly tolerant of small scandals now that they have endured a series of massive corporate failures.

Of course the full dimensions of the mutual fund scandal are still far from known. So far only four of the nation’s nearly 800 mutual fund companies have been named, but Spitzer has said more companies will be identified. In any case, plenty of damage already has been done, said Russel Kinnel, senior fund analyst at independent research firm Morningstar.

“Unfortunately (the mutual fund industry) can no longer claim to be scandal-free, both because of the seriousness of the charges and the prominence of the firms involved,” Kinnel said. “They’re not the biggest, but they’re big and well-known, and most investors felt confident in trusting them.”

InsertArt(2010974)He said there is no need for fund holders to panic, because the proscribed practices presumably have been stopped. There is little or no danger that shares of the affected funds will spiral downward like shares of companies that were involved in earlier scandals, he said. But he suggested that shareholders take a “long, hard look” at any investments they might have in funds managed by the firms names so far, Janus, Strong, Banc One and Bank of America’s Nation’s Funds.

“There are a lot of ethical players in the fund industry,” he said. “Why would you want one with a cloud over it?”