Illegal Fund Trading Rampant

I have to give credit to my fellow Fool Bill Mann (TMF Otter). When news about the mutual fund trading scandal broke last week, he wrote, "I'd bet that we've only seen the first allegations. There is a tendency in business that somehow seems to be amplified on Wall Street: That which makes money is done to excess."

Sure enough, a study released yesterday by Stanford professor Eric Zitzewitz indicates fund shareholders may be fleeced for some $400 million over the course of an average year through the practice of "late trading." That's when mutual funds allow certain investors -- usually hedge funds -- to trade at the 4 p.m. closing price well after 4 p.m.

It's almost like free money, because the hedge funds can buy or sell on news that will affect the next day's price. Any money made in this manner comes out of the value of the mutual fund and, therefore, the pockets of its investors. Oh, and it's illegal. Mutual funds presumably allowed this to happen in exchange for the hedge funds' business in other areas.

"This," Zitzewitz said, "is such an egregious violation of a fund manager's fiduciary responsibilities that one might suppose that it was limited to a few isolated cases." However, he found statistically significant evidence of late trading in 15 out of the 50 international fund companies in his dataset and in 12 out of 96 domestic fund families.

Through an agreement with his data provider, Zitzewitz said he couldn't name any of the funds involved. Thus far, New York Attorney General Eliot Spitzer has implicated mutual fund managers from Bank of America (NYSE: BAC), Janus (NYSE: JNS), Strong, and Bank One (NYSE: ONE) in both late trading and a related practice known as "market timing." But, he says, "The full extent of this complicated fraud is not yet known."