By the end of the summer, mutual fund investors had read about a few scattered incidents of improper practices that undercut shareholder returns. But the stories were easy to shrug off, appearing to affect only some investors in a handful of funds – and not causing very significant losses even for them.


But in early November, the picture is far different, with the $7 trillion fund industry in the biggest crisis of its history for abuses such as late trading, market timing and self-dealing by fund executives. Several brokerages and fund families are under investigation by the Securities and Exchange Commission, the NASD and state regulators in New York and Massachusetts. Many top fund officials have been fired or compelled to step down. Congress has begun hearings.


On Nov. 3, Putnam, for example, the country’s fifth largest fund company, said its chief executive would leave after federal and state prosecutors accused the firm of fraud involving personal trading that enriched fund managers at their shareholders’ expense. Institutional investors have reacted by pulling some $4 billion out of Putnam funds. Earlier, the chairman of Strong Funds, founder Richard S. Strong, resigned amid allegations he had improperly traded the company’s funds in his personal account. Other funds with troubles include Bank of America, Bank One, Alger Funds, Alliance Funds, Federated Funds and Janus Capital Group.


Underscoring the growing seriousness of the scandals, the head of the SEC’s New England office said Nov. 3 that he would step aside because of criticisms his office had failed to act quickly on tips about Putnam.


As the investigations deepened, The SEC announced Nov. 4 that it had filed civil fraud charges against five former brokers for Prudential Securities, the brokerage firm. The charges allege the brokers went to extraordinary lengths to market-time various funds, even as the fund companies tried to block the activity.


Now, instead of a few disciplinary actions, broad reform seems likely.


“I have yet to see data that shows me the extent of this abuse, but I know it happens,” says Wharton finance professor Jeremy Siegel. “I have been following these market timing newsletters for years. In these newsletters, they even say, ‘Oh, this fund has shut us down, but we have established a relationship with this other fund that lets us do this.’ Now I realize what is [going on] and it’s very upsetting … I think it’s going to take a very lengthy detailed examination to know whether this is amounting to substantial dollars or not.”


Some estimates suggest that abusive trading reduces shareholder returns by about 1 percentage point a year. While some investors might shrug that off, it can do great damage to long-term compounding if it is continuous. An investor who saves $10,000 a year at an 8% return would have $458,000 after 20 years. If abusive trades cut the return to 7%, the portfolio would grow to only $410,000, about 10% less.


Two practices are at the heart of the scandal: In late trading, which is illegal, favored investors are allowed to place orders to buy or sell fund shares after the 4 p.m. market close in New York, while still receiving the 4 p.m. price based on the value of the fund’s assets at the time. By law, orders after the close are to be filled at the next day’s closing price. Late traders thus have the advantage of being able to act on late-breaking news such as corporate earnings reports, or on price changes of stocks traded on foreign markets that are open when U.S. markets are closed.


The second practice, market timing, is illegal only if the fund company has policies to prevent it, which many funds do. Again, favored investors have been allowed to make short-term bets that other investors were not allowed to make.


In its correct usage, market timing simply means trying to buy low and sell high, according to Andrew Metrick, finance professor at Wharton. The current fund scandals actually involve trading based on “stale” or out-of-date prices. This has being going on for many years, Metrick adds, arguing that most fund companies want to prevent it but have had trouble figuring out how.


Profits earned by late traders and short-term market timers come out of the funds’ assets, reducing the value of shares owned by other investors. It is as if an investor were allowed to buy a stock trading at $10 a share today, but to pay yesterday’s price of $9. The supplier of the stock – a brokerage or fund company – would have to pay $10 to acquire the share to fill the order, thereby suffering a $1-per-share loss. With a fund, that loss is borne by the other shareholders.


In testimony at a Senate Governmental Affairs subcommittee hearing Nov. 3, SEC enforcement chief Stephen M. Cutler said that a quarter of the brokerage firms surveyed, and 10% of the fund companies, had permitted late trading.


A brokerage typically bundles customer orders for a specific fund into one omnibus account in the brokerage’s name, then passes the net buy or sell order to the fund an hour or two after the market closes. Because of this, it is easy for a brokerage to allow customers to make late trades without the fund’s knowledge or participation. It is not yet clear how many fund companies willingly participated in abusive trading.


On Oct. 30, the Investment Company Institute (ICI), the fund industry’s trade group, urged the SEC to adopt rule changes to curb abuses. The first would require that funds give the 4 p.m. price only to investors whose orders had been received by the fund before that deadline. To allow time for paperwork, fund companies and brokerages would thus have to set even earlier deadlines.


Metrick says this is a good remedy that requires new industry regulation. A fund company cannot set earlier deadlines on its own because investors, though benefiting from the rule, might prefer competitors with later deadlines. “If they all do it at once, and perhaps regulators will force them to, it will be much better.”


Wharton finance professor David Musto believes the deadline should be several hours before 4 p.m., to give fund managers time to buy and sell securities needed to meet shareholder orders. Funds can, and do, hold some cash, but they are supposed to put investors’ money to work as quickly as possible. This is especially hard with small and foreign stocks that may be thinly traded. Fund managers therefore need plenty of time to put cash received during the day to work before the market’s close, Musto said. “The earlier the better,” he says of the deadline.


Funds that have a hard time investing quickly, perhaps because they buy thinly traded stocks or foreign issues, could be required to fill orders at the following day’s prices, he suggests. Or they could be required to adopt a “fair value” pricing system that would, for example, take into account the intraday price changes on foreign markets.


In addition, he notes, regulators should consider banning the large omnibus accounts held at brokerages, so that the fund companies would know the identities of all their shareholders and could track their activities. “That would be very straightforward. Mutual fund families know that the problem is these omnibus accounts.”


The ICI also asked the SEC to require funds to charge a 2% fee on fund shares sold within five days of being purchased. The fee would discourage quick trades by making them unprofitable. Fee proceeds would be added to fund assets to offset damage from market timing.


Metrick, while not generally enthusiastic about fees as a remedy, says the approach could work if the fees are poured back into the funds rather than contributing to management company profits.


Siegel would prefer to see regulators encourage funds to set earlier deadlines and to charge fees for early redemptions, but he does not think these practices should be mandatory. Instead, he says, funds should be required to clearly disclose whether they have such policies and to describe the potential hazards to investors if they do not. “Mandatory disclosure would cut a lot of it out,” he suggests.


The fund scandal is evolving so rapidly that it may be too soon to tell the full range of problems that need to be addressed. The SEC has already made it clear, however, that it will set new rules for the fund industry, with proposals likely by the end of November. While the commission has not said what those rules would be, a 4 p.m. deadline like that proposed by the ICI appears likely, as is some sort of curb or disclosure requirement on market timing. Indeed, the SEC may go farther by requiring that more outsiders occupy seats on the fund companies’ boards of directors.