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Is the Mutual Trust Broken?

The scandal of 2003 is such a pivotal event since the advent of the mutual fund industry in 1940 that there are two salient facts about it that will undoubtedly be remembered in years to come. Its magnitude and its stealth.

That there were white-collar criminals and ethically challenged executives among us seemed to come as a surprise. Or, did it? Should it have?

There was no lone journalist to blow the lid off this story, as the Fortune writer, tipped off by a short seller, did with Enron. But the signs were all there - and we were reporting on them all along (see "Perils of Market Timing - You Read it Here First" reprint from 12/9/02, page 12).

In hindsight, the full story was revealed only in bits and pieces, and from a standpoint that prevented us those who worked within and covered, from the outside, the mutual fund industry from realizing that late trading could - and did - occur.

Only the lone crusader, New York Attorney General Eliot Spitzer, realized how the defacto standard operating procedures in the fund industry - pushing product, revenue sharing, selective disclosure and, in some cases, market timing - were not always ethical or conscionable.

In fact, one of the key sources in the mutual fund late trading scandal of 2003 approached a reporter at another publication here at Thomson Media. This same source also approached The Wall Street Journal and The Boston Globe and begged them to investigate the story. But it seemed implausible that hedge funds would be market timing or late trading mutual funds at any great rate for a number of good reasons, not least of which was the difference in retail and institutional fees.

Except for the padding of management fee-producing assets and brokers' commissions during a difficult bear market, it just didn't make sense in the grand scheme of things.

But the trading and complicit and illicit arrangements between some fund companies and their hedge fund partners should have raised red flags. Once again, like the dot-com debacle of 2000, where there is any great money at stake there is great opportunity for transgression.

The mutual fund trading scandal of 2003, or Fundgate, as we call it, is about far more than going over the line and breaching generally accepted business practices of directed brokerage and soft dollars. But while there were numerous fringe voices in 2000 saying the Internet bubble was about to burst, there was not one single, seminal report announcing that event, as there was not this year ahead of the Spitzer curve.

Wanting to Believe

There is a lesson to be learned here, of course. As much as all of us wanted to believe that the mutual fund industry was built upon a rock-solid foundation of integrity and trust, once again, it came down to money.

Where there is money to be made, there is always room for the criminal mind. And regardless of whatever fines and restitution the industry ponies up, even if it's the $10 billion Spitzer has bragged about, ours is a money management business that warrants careful attention. Investors know that. They won't leave us. We are their conduit to a safe and sound retirement. But we owe it to ourselves and to the end investor to carefully etch that in our minds, once and for all.

Copyright 2004 Thomson Media Inc. All Rights Reserved.