Mutual Funds: Study Says Illegal Trading Common

As regulators step up their probe into allegations of improper activity by mutual funds, a new study suggests illegal late trading may be more widespread than previously reported.

The study by Stanford University Prof. Eric Zitzewitz found that late trading — in which investors are allowed to trade after the close of markets at preclosing values — appears to be happening in one out of six mutual fund families, at a cost to ordinary investors of about $400 million a year.

"I didn't think it would be as widespread than it was since late trading is so illegal — and illegal in a way that almost everyone in the industry understands," Zitzewitz said.

A mutual fund lobbying group, however, criticized the study's methodology and said Zitzewitz could not really determine that late trading occurred.

"There's a number of open questions that the paper does not fully address," said Brian Reid, senior economist at the Investment Company Institute.

The study comes as New York Attorney General Eliot Spitzer and the Securities and Exchange Commission announced criminal and civil charges Tuesday against former Bank of America employee Theodore Sihpol over late-timing activity they say cost investors millions of dollars.

Firms Accused of Late Trades

Spitzer has accused hedge fund Canary Capital Partners LLC of illegal trading involving Bank of America, Janus, Bank One Corp. and Strong Financial Corp. funds. Spitzer has cited other studies by Zitzewitz to tally the financial consequences to ordinary investors and said, in announcing the charges against Siphol Tuesday, that more criminal charges were sure to come.

The mutual funds have denied illegal activity, and other mutual and hedge funds have been subpoenaed in the case.

"It certainly is worrisome to see indications of more late trading going on," said Russ Kinnel, director of funds research at Morningstar Inc. "It suggests there is work for regulators to do, and that mutual fund companies need to tighten up compliance to make sure it doesn't happen."

Both Spitzer's office and the SEC said they were reviewing the study. They declined to comment further.

Problem Prevalent in International Funds

Zitzewitz's study examined daily cash flow data in 104 fund firms from 1998-2001 and found evidence of late trading in 16 of them.

The problem was more prevalent in international funds, with signs of the trading in 15 of 50, resulting in a cost to ordinary investors of about a nickel for every $100 invested. Among domestic funds, late trading appeared to occur in 12 of 96 fund families, costing shareholders less than a penny per $100 invested.

Zitzewitz, a consultant to a company that manages mutual fund data and offers services to help funds fight improper trading, declined to name specific companies, citing a previous confidentiality agreement with TrimTabs Investment Research, which provided the fund flow data.

The research does exclude several fund firms that couldn't be evaluated because they provide monthly, rather than daily, fund flows. They are Fidelity Investments, the Vanguard Group, Janus Capital Group and MFS Investment Management.

The study drew quick criticism from the Investment Company Institute. The group noted that the study is based on fund flows, and not actual records of trades, so the fund flow activity after 4 p.m. might be explained by other reasons, such as legal futures trading.

"From the data he has presented and the methodology he used, he cannot conclusively make the determination he has," Reid said.

What Do Fund Companies Know?

Kinnel and Roy Weitz, publisher of, said they believed the research looked sound but said the bigger question might be whether mutual fund companies were complicit in the apparent late trading.

Spitzer's complaint against Siphol alleges Bank of America's involvement; in other cases, however, it is believed that hedge funds might have conducted trades with the help of an intermediary without mutual fund companies' knowledge.

Zitzewitz said the timing of the fund flow data in the after hours strongly pointed to late timing rather than other alternatives. He agreed that the study does not necessarily implicate fund firms but instead suggests late trading is prevalent — whether fund firms knew it or not.

"A fund company could potentially use these methodologies to figure out if they have late trading," he said. "I should say that boards of directors would really want to insist that funds run these sorts of tests."

Leon Ostrowski, 62, a mutual-fund investor in Plover, Wis., said he wasn't terribly concerned about the charges of late timing. He plans to keep track of which firms are accused or charged with violations, but doesn't intend to sell off large amounts of assets otherwise.

"There have been too many things to be disillusioned about in the stock market over the years to get too worried about this," he said. "I have faith the regulators will catch the wrongdoers."