Ever since Enron collapsed into a smoldering heap nearly two years ago, regulators and lawmakers have scrambled to shore up confidence in the nation’s financial markets and corporate boardrooms.They’ve passed the Sarbanes-Oxley Act; they’ve slapped Wall Street firms with huge fines. But the cleanup is far from over. Regulators’ next target? The $6.8 trillion mutual fund business.

Turns out the industry that has long claimed to be the friend of the little investor and the champion of corporate responsibility has quite a few unsavory secrets of its own. Most of them center on unseen fees and conflicts of interest in the way funds are sold. “There are undisclosed financial motivations in damn near every transaction involving mutual funds,” says Edward Siedle, a former mutual fund executive and attorney for the Securities and Exchange Commission who now investigates abuses at money-management firms for pension funds. The upshot: More of the dollars you’ve invested in mutual funds are being squandered than you ever dreamed. And in trying to fix the worst abuses, regulators and lawmakers could deliver yet another blow to the already shaky Wall Street firms that peddle the lion’s share of the fund industry’s offerings.

Several iffy practices spark the most concern at the SEC (see following interview with SEC chairman William Donaldson). One is directed brokerage, in which a mutual fund company agrees to do a certain volume of trades with a given brokerage if that firm agrees to distribute its funds. Another is revenue sharing, in which a fund company pays brokers part of its own profits to push its funds to investors. Those deals, while legal, are little more than kickbacks. Most shocking of all, perhaps, are the so-called soft dollars embedded in commissions that flow from fund companies to brokerage firms and back again. They are supposed to be for research but often wind up paying funds’ routine costs of doing business (more on that later).

Those practices are a big reason most large fund groups pay a hefty 5 cents a share in brokerage commissions when many trades can be done on electronic exchanges for less than a penny. The money spent on those commissions belongs to investors, mind you, not to the fund companies. Mutual funds are set up like mutual insurance firms: The fund assets belong to the shareholders collectively, not to the company. And while sky-high transaction commissions hurt the fund’s overall return, they aren’t part of its much-touted “expense ratio.” That ratio includes management fees and marketing expenses and is used by investors to gauge whether a fund is “low cost” or not.

All those nickel-a-share trades add up. Last year the mutual fund industry paid brokers about $6 billion in commissions. Anywhere from $1 billion to $4 billion–no one knows for sure–went for something other than simple trade execution (see chart). Trading costs can easily double the annual expense of a mutual fund. “Right now the average annual expense ratio for a mutual fund is about 1.3%, but when you add up trading costs and all the other fees, you can get up to 3% in annual costs,” says Gary Gensler, former undersecretary of the U.S. Treasury and co-author of The Great Mutual Fund Trap. Don’t think 3% a year is a big deal? Well, since 1982, that’s how much the average equity fund has lagged behind the S&P 500 stock index. Translation: $10,000 invested in the average equity fund 20 years ago is now worth $56,765, vs. $105,250 if it had been invested in the stock market.

You’d think the mutual fund industry would have plenty of other ways to compensate brokers. After all, for decades most funds have carried “loads” of up to 8.5%, which go to the sellers. Funds also charge a so-called 12b-1 fee to cover administrative and marketing costs, limited to 1% of the fund’s assets annually. That’s in addition to those revenue-sharing arrangements.

Thanks in part to those broker incentives, over the past two decades the industry has exploded. Today some 400 mutual fund companies vie to sell investors more than 8,200 stock and bond funds; assets have surged from $56 billion in 1978 to around $6.8 trillion. Only about 38% of funds (excluding money market funds) are “no loads” sold directly through toll-free numbers or through fund supermarkets like Charles Schwab’s OneSource. (To be included on Schwab’s list, fund companies do pay an annual fee of 0.4% of assets sold through Schwab.) The rest are sold through financial advisors, insurance agents, or brokers such as Merrill Lynch or A.G. Edwards.

But times have gotten tough for Wall Street firms. Their usual moneymakers–equity underwriting and advising on mergers and acquisitions–are in the dumps for the third consecutive year. So, some mutual fund executives say, the firms’ brokerage units are trying to squeeze more money out of them. “Almost every day I get a call from a broker saying another mutual fund group is willing to pay ten basis points in fees and I’m only paying six basis points in fees,” says an executive at a mutual fund firm. He says the message is that if he doesn’t match the other group’s offer, the sales force won’t aggressively sell his funds. “In essence, whoever the highest bidder is will get shelf space and be sold by the firm,” he continues. “This is the way the industry operates. And if you don’t play by the rules, it’s going to be difficult to succeed.”

Regulators worry that investors don’t know enough about broker- fund relationships. Revenue sharing may induce brokers to put small investors into a fund that gives a bigger piece of its profit pie to the brokerage, not into the fund that’s best for the investors. Additionally, if fund companies are including revenue-sharing fees as part of the fund’s overall expenses, investors may be subsidizing their fund’s marketing efforts more than they should. Consider this: Large institutions such as pension funds pay as little as 0.1% in fees for money market funds. Some retail investors are paying 1%, or ten times as much, for those same funds. “There’s no reason Calpers [the California state employees’ pension system] pays one-quarter to one-fifth as much as a retail mutual fund investor in fees for the same large-cap value fund,” says fund investigator Siedle. “The only difference is that the mutual fund company has to pay brokers to persuade investors to purchase their fund.”

Then there’s the practice known as directed brokerage, in which fund companies use trading commissions to pay brokers to distribute their funds. That’s allowed, but only within certain limits. The commission costs are supposed to be accounted for in the 12b-1 fee. But industry insiders and regulators say that’s not happening. In fact, some say that if fund companies did start accounting properly for the fees, it might send some of them over the total brokerage compensation limit of 8.5% allowed by the National Association of Securities Dealers.

But the biggest gorilla that regulators are wrestling is what else–besides actual trading–mutual fund advisors get for their nickel a share in trading commissions. Under the “safe harbor” law enacted in 1975, it’s perfectly legal for mutual funds to receive research and other brokerage services in exchange for trading commissions as long as they believe they are achieving “best execution” for their trades. Sounds vague? It is. And that’s part of the problem. Says John Bogle, founder of the giant no-load fund family Vanguard Group, who has become one of his industry’s sharpest critics: “Under the rubric of research, all sorts of subtle and not-so-subtle abuses are occurring.”

He’s talking about soft dollars. Here’s how they work. Say a mutual fund company decides it wants 30 Bloomberg terminals at a cost of $1,500 a month, or $45,000 annually, but doesn’t want to pay for them from its own pocket. So it arranges for the broker to pay the fund company’s monthly subscription costs. In exchange, the fund company spends, say, $67,500 in trading commissions by the end of the year.

Amazing as it may seem, that’s perfectly legal. The Bloomberg terminals are construed as “research and other services” provided by the brokerage firm. Those other services can be phone bills racked up by the fund company, software and computers, subscriptions to financial publications, and lawyers’ fees. It’s a neat way for fund companies to maintain their own profits at shareholder expense: Since the expenses are accounted for as part of the fund’s commissions, the spending sprees come out of the fund’s assets but don’t show up in its reported expense ratios in the prospectus. “There was a time when I purchased some accounting software, and the salesman in my office was incredulous because I was going to write a check for the software,” recalls John Montgomery, president of Bridgeway Funds, a small no-load fund firm in Texas. “He couldn’t believe I was going to use the firm’s money when I could use the shareholders’ money.”

A 1998 SEC audit of investment firms found that in exchange for trading commissions, 28% had received goods or services that didn’t fall within soft-dollar guidelines. (Hedge funds were the most egregious abusers, using soft dollars to pay office rent, hotel and rental-car costs, even employees’ salaries.) Have things gotten better since then? Nobody knows–but it seems unlikely. “If a fund’s assets are going down in a bear market, as we’ve seen, the way you keep your operating margins up is to either cut expenses or pay more in commissions and use that to pay expenses,” says Harold Bradley, a senior vice president at big mutual fund company American Century Investments and an outspoken soft-dollar critic. (Last year American Century executed nearly half its U.S. trading through electronic exchanges for less than a penny a share.)

Furthermore, while money managers may say they do trades because of in-house research provided by Morgan Stanley or Goldman Sachs, others claim it’s yet another backdoor way to pay brokers for distribution. “If you want to use Merrill Lynch to sell the funds, you can have Merrill send over some crappy research, and then you can show regulators a pile of research three feet high that backs up why you did the trades,” says a former mutual fund executive. “If the SEC really wanted to pursue this, they could do it just as Eliot Spitzer did with Wall Street. Start asking for e-mails.”

The SEC hasn’t done that yet. Chairman Donaldson has declined to give specifics about what actions the SEC will take–and when. But another SEC examination of mutual funds’ soft-dollar habits seems likely. And in hearings this summer, Paul Roye, director of the SEC’s division of investment management, suggested that Congress should narrow the scope of the 28-year-old laws that govern many of the practices now under scrutiny. Meanwhile, Britain’s Financial Services Authority has introduced a proposal to pull apart trading costs from research and other services that mutual funds receive from brokers. Any changes the group makes–a decision is expected this fall–will be closely watched by U.S. regulators.

A ban on soft dollars, which Vanguard’s Bogle and others are advocating, would have a huge impact. If fund companies had to start footing the bill for expenses they now foist onto investors, their hefty profit margins (estimated to be as high as 45% pretax) could be hit hard. The effect on Wall Street could be even bigger. Daniel Goldberg, a research analyst at Bear Stearns, says that if fund companies began conducting more trades on electronic exchanges, it could easily knock as much as 15% a year off earnings at Merrill Lynch, Goldman Sachs, and Lehman Brothers. And if regulators clamp down hard on directed brokerage, that could cause commission costs to fall further. “You would see trades drop to 3 cents a share,” says Siedle. “That would really hurt brokerage firms that have to maintain a sales force.”

Some fear that a ban on soft dollars would deal a terrible blow to independent third-party research. “Now that research can’t be compensated by investment banking, regulators need to be careful that they don’t destroy all of the income sources for research,” says Lee Pickard, a partner at law firm Pickard & Djinis, which represents both mutual fund companies and brokerages. “We’ll end up with only large money managers who can support in-house research dominating the market.”

Thanks to powerful industry lobbying, there’s little chance soft dollars will disappear anytime soon. In fact, a bill introduced earlier this year by Richard Baker (R-Louisiana) before the House Committee on Financial Services has already removed language that could have repealed the “safe harbor” laws, along with some other initiatives. The bill’s measures now simply require greater transparency–mutual funds and brokerages will have to tell investors about any revenue-sharing agreements–and some increased recordkeeping. The soonest the bill might come up for vote is later this year. In mid-August the NASD also proposed that brokers be required to tell investors more about how funds compensate them.

In the end, what will come out of all this talk of reform? If history is any guide, very little. Five years ago the SEC made a great show of calling for increased disclosure–yet here we are. Telling investors there are conflicts of interest is not the same as eliminating those conflicts. So what is a beleaguered fund investor to do? Right now, the best advice may be to vote with your feet: Move to no-load index funds.

FEEDBACK jcreswell@fortunemail.com

Where the Nickel Goes

The typical mutual fund pays a broker 5 cents per share in

trading commissions. But less goes for actual trading than you

might imagine.

36% — Sell-side research

Fund companies say that this 36%–nearly 2 cents per share–goes

for research. Some insiders say it’s mostly disguised kickbacks

to brokers for selling the funds.

35% — Trading and execution

Nearly two pennies go for pure trading–twice what an electronic

exchange would charge.

11% — Distribution and directed brokerage

These are incentives to brokers to sell the funds.

10% — Other research and data

These include things like Bloomberg terminals, Sanford C.

Bernstein reports, lawyers’ fees, and other soft-dollar goodies

that come back to the fund.

5% — Access to new issues

When the IPO market is hot, this percentage can jump

significantly.

Other

Quote: “He couldn’t believe I was going to use the firm’s money when I could use the shareholders’ money.”