About 95 million Americans rely on mutual funds to invest and protect trillions in savings that they hope to use to educate their children, buy new homes and help fund their retirements.
But a growing scandal in which a number of firms have been accused of cheating small investors to help their largest customers is causing many to lose faith in the industry.
"I think it is probably the most significant undermining of the public interest since any of these corporate scandals first erupted," Arthur Levitt, former chairman of the Securities and Exchange Commission, said in an interview with The Sun on Friday, as investors pulled their money out of Boston-based Putnam Investments, which faces federal and state fraud charges. "I think a lot of confidence has been shaken."
"I think a lot of investors in the back of their minds must think, `Gee, what kind of industry is this?' " said John Bogle, founder of the Vanguard Group, a giant Pennsylvania mutual fund company, and an industry critic. " `Gee, this industry has a lot of problems. I still like mutual funds; are there any honest ones out there?' "
The damage has been so deep and the level of concern so high that Congress will begin hearings tomorrow on the scandal and what can be done to reform the industry.
Meanwhile, many mutual fund companies are scrambling to reassure investors, while others have remained silent because of subpoenas issued to a large number of industry firms.
Executives at Baltimore-based mutual fund companies say they are bracing for more bad news.
"We can't anticipate what the trend is, but my guess is we'll continue to see more items uncovered as we go forward," said Scott Such, vice president of T. Rowe Price Services, a unit of T. Rowe Price Associates Inc., the Baltimore-based mutual fund company. "I don't think this is done. I think they've got a lot of investigating to do. I'm surprised by some of the stuff we've seen so far."
The first sign that anything was wrong came in early September, when New York Attorney General Eliot Spitzer accused several large mutual fund companies of giving a large hedge fund, Canary Capital Partners LLC, preferential treatment. The funds allowed Canary to make after-hours trades and use rapid-fire trading techniques to gain an advantage over other investors.
The investigation broadened last week as Massachusetts securities regulators and the SEC slapped Putnam Investments, the country's fifth-largest mutual fund company, with civil fraud charges.
The actions were the first civil lawsuits brought against a mutual fund company. Putnam and two fund managers are accused of allowing market-timing trades even though company policy prohibits the practice.
Investigators for Spitzer also alleged last week that Richard Strong, the founder of Wisconsin-based Strong Funds, made hundreds of thousands of dollars at the expense of investors through improper short-term trading in his company's own mutual funds.
"The Dick Strong thing is just breathtaking," Bogle said. "How can anybody be such a sap when he is worth a billion bucks? Why even waste his time doing it, even thinking about it?"
Some mutual fund experts say the industry, once billed as the investment tool for the common man, has lost its moral compass in the pursuit of higher profits.
"I think it's very clear that this is an industry that was sort of set up with the notion of putting the investor first, but somewhere along the way there seems to have been a shift so that fund companies seem more interested in serving their own stockholders rather than the people whose funds they manage," said Russ Kinnel, director of fund analysis at fund tracker Morningstar Inc.
The controversy, Kinnel said, will speed the migration of fund investors to high-quality companies that have stayed focused on investors.
"It's worth pointing out that there are still a lot of clean people in the business," he said. "And for most Americans, I still think this is the most sensible way of investing for the long term."
The mutual funds under investigation have gotten into trouble by allowing customers to time the market and make after-hours trades.
Late trading allows an investor to place trades after the 4 p.m. closing bell. It gives them an unfair advantage over other investors because they have the entire day to act on news while others don't.
Market timing, which is not illegal, enables investors to trade in and out of funds rapidly, and can hurt a fund's performance over time. The practice typically generates lots of fees and commissions, which can ultimately increase costs to other investors.
It also places a burden on fund managers, forcing them to keep more cash on hand to keep up with large redemption requests. That leaves less money for managers to invest in equities that could produce a higher return for shareholders.
Reforms aimed at eliminating these practices are expected to be proposed by both Spitzer and SEC officials at tomorrow's hearing before a Senate Governmental Affairs subcommittee.