Some investment experts have always believed that illegal trades in mutual fund shares is a serious problem that hurts unsuspecting ordinary investors. And now, because of a probe led by New YorkAttorney General Eliot Spitzer, it may receive well-deserved attention.

For years, professional investors, such as hedge funds, and devoted individual investors have used “market-timing” strategies in the mutual fund market, taking advantage of the difference between funds’ closing share prices and the market value of securities in which these funds invest.

With Wednesday’s announcement of a new probe into alleged illegal trading schemes accommodated by mutual fund companies, Spitzer shed new light on the issue, which, some experts say, had cried out for more stringent oversight from fund companies and financial regulators.

Catching many in the fund industry by surprise in particular is Spitzer’s claim that four fund families – Bank of America Corp.’s Nations Funds, Bank One Corp., Janus Capital Group Inc. and Strong Funds – permitted favored companies and individuals to engage in illicit trading while stating in their fund prospectuses that they discourage or prohibit such practices.

Painting himself as a protector of small investors, Spitzer’s office filed a complaint against hedge fund Canary Capital Partners that claims the four mutual fund companies allowed Canary to conduct “late trading” and “timing” of their mutual fund shares in exchange for payments and other inducements.

Late trading is prohibited by law as it allows preferred investors to buy fund shares at the 4 p.m. EDT closing price after the market closes, while other investors can receive that price only if they buy before the close. Spitzer says the problem appears to be widespread and could be costing investors billions of dollars each year.

Fund industry experts say such activity by a small group of people hurt the vast majority of ordinary investors by increasing the funds’ trading costs. It also often forces fund managers to buy or sell securities against their will by suddenly pouring large sums of money into funds only to withdraw them soon after.

According to a study by the Stanford Graduate School of Business’ Eric Zitzewitz published late last year, U.S. mutual funds lose $4 billion a year because of market-timing, roughly double the levels from 1989 to 1999. He also said in the report that the solutions to market-timing problems that have been adopted by the fund industry have “serious shortcomings” despite the availability of effective and low-cost measures.

“Short-term traders really affect the long-term performance of mutual funds,” says J. Alan Reid, president of San Francisco fund company Forward Funds. “The scary thing is it’s people’s retirement money and college savings that are paying for these market timers.”

Reid, who also runs a new company specializing in market-timing solutions aimed at mutual funds, believes 60 percent of the trading volume of the average mutual fund is generated by short-term players.

Market timers often target international funds, where they benefit from large pricing gaps created by time differences, funds investing in illiquid securities such as small-cap stocks, and high-yield and municipal bonds.

If proven true, Spitzer’s claim that some fund companies actively accommodated market-timing by certain investors in exchange for payments would deal a serious blow to the fund industry and hurt investors’ trust in the industry.

Many mutual fund investors have assumed that everybody – whether a hedge fund or an individual – has been on a level playing field. Spitzer’s announcement showed it may have been otherwise.

“It’s certainly a situation which the fund industry wants to nip in the bud,” says Donald Cassidy, senior research analyst at fund tracker Lipper Inc. He thinks this could lead to new regulatory action or a voluntary rule by the industry that would require fund companies and their senior executives to certify their rules on market-timing, and hold them responsible when such rules are broken.

The reaction from the fund industry to Wednesday’s announcement was terse. Matthew Fink, president of the Investment Company Institute, said in a short statement that “the legal standards and duties regarding trading and valuations of mutual fund shares are clear and long-standing” and that the industry supports strict compliance with and vigorous enforcement of the law on behalf of investors.

Spitzer’s action was at the same time “extremely embarrassing” to the Securities and Exchange Commission, which has been aware of the problem but has failed to take enforcement action, says Mercer Bullard, a securities law professor at the University of Mississippi and a leading mutual fund investor advocate.

NEW YORK (AP) – Some investment experts have always believed that illegal trades in mutual fund shares is a serious problem that hurts unsuspecting ordinary investors. And now, because of a probe ledby New York Attorney General Eliot Spitzer, it may receive well-deserved attention.

For years, professional investors, such as hedge funds, and devoted individual investors have used “market-timing” strategies in the mutual fund market, taking advantage of the difference between funds’ closing share prices and the market value of securities in which these funds invest.

With Wednesday’s announcement of a new probe into alleged illegal trading schemes accommodated by mutual fund companies, Spitzer shed new light on the issue, which, some experts say, had cried out for more stringent oversight from fund companies and financial regulators.

Catching many in the fund industry by surprise in particular is Spitzer’s claim that four fund families – Bank of America Corp.’s Nations Funds, Bank One Corp., Janus Capital Group Inc. and Strong Funds – permitted favored companies and individuals to engage in illicit trading while stating in their fund prospectuses that they discourage or prohibit such practices.

Painting himself as a protector of small investors, Spitzer’s office filed a complaint against hedge fund Canary Capital Partners that claims the four mutual fund companies allowed Canary to conduct “late trading” and “timing” of their mutual fund shares in exchange for payments and other inducements.

Late trading is prohibited by law as it allows preferred investors to buy fund shares at the 4 p.m. EDT closing price after the market closes, while other investors can receive that price only if they buy before the close. Spitzer says the problem appears to be widespread and could be costing investors billions of dollars each year.

Fund industry experts say such activity by a small group of people hurt the vast majority of ordinary investors by increasing the funds’ trading costs. It also often forces fund managers to buy or sell securities against their will by suddenly pouring large sums of money into funds only to withdraw them soon after.

According to a study by the Stanford Graduate School of Business’ Eric Zitzewitz published late last year, U.S. mutual funds lose $4 billion a year because of market-timing, roughly double the levels from 1989 to 1999. He also said in the report that the solutions to market-timing problems that have been adopted by the fund industry have “serious shortcomings” despite the availability of effective and low-cost measures.

“Short-term traders really affect the long-term performance of mutual funds,” says J. Alan Reid, president of San Francisco fund company Forward Funds. “The scary thing is it’s people’s retirement money and college savings that are paying for these market timers.”

Reid, who also runs a new company specializing in market-timing solutions aimed at mutual funds, believes 60 percent of the trading volume of the average mutual fund is generated by short-term players.

Market timers often target international funds, where they benefit from large pricing gaps created by time differences, funds investing in illiquid securities such as small-cap stocks, and high-yield and municipal bonds.

If proven true, Spitzer’s claim that some fund companies actively accommodated market-timing by certain investors in exchange for payments would deal a serious blow to the fund industry and hurt investors’ trust in the industry.

Many mutual fund investors have assumed that everybody – whether a hedge fund or an individual – has been on a level playing field. Spitzer’s announcement showed it may have been otherwise.

“It’s certainly a situation which the fund industry wants to nip in the bud,” says Donald Cassidy, senior research analyst at fund tracker Lipper Inc. He thinks this could lead to new regulatory action or a voluntary rule by the industry that would require fund companies and their senior executives to certify their rules on market-timing, and hold them responsible when such rules are broken.

The reaction from the fund industry to Wednesday’s announcement was terse. Matthew Fink, president of the Investment Company Institute, said in a short statement that “the legal standards and duties regarding trading and valuations of mutual fund shares are clear and long-standing” and that the industry supports strict compliance with and vigorous enforcement of the law on behalf of investors.

Spitzer’s action was at the same time “extremely embarrassing” to the Securities and Exchange Commission, which has been aware of the problem but has failed to take enforcement action, says Mercer Bullard, a securities law professor at the University of Mississippi and a leading mutual fund investor advocate.