Mutual funds--the next big thing.

• Author: Shepler, Bob
• Position: Washington Insights

The next big issue Congress will tackle in 2004 will be mutual fund abuses. By now, you have seen daily news stories about "market timing" and "late trading" abuses at brokerage firms and mutual funds, and the response from regulators and industry regarding the need for reforms. Congress is also looking into mutual fund abuses, and several bills have been introduced, but time is running out for this Congressional session.

At issue are charges of market timing (short-term trading to take advantage of prices on foreign markets) and late trading (allowing a trade to be processed after the day's 4 p.m. deadline for trades).

Market timing may not be illegal, but it is certainly unethical, because it hurts long-term shareholders; as a result, the practice is discouraged by most funds. However, allegations have been made that some brokerages and mutual funds have publicly stated that they discourage market timing, but then have turned around and actually assisted larger clients, including hedge funds, time the markets. This activity may rise to the level of illegality.

Late trading, however, clearly is illegal. Late trading occurs when a mutual fund manager allows a trader to buy or sell shares of the fund at the 4 p.m. closing price, at say 7 p.m., instead of at the next day's closing price. If a major stock-moving event occurs after the close of trading, the late trader can profit.

On October 30, the House Financial Services Capital Markets Subcommittee held a hearing to discuss market structure issues and, more particularly, mutual fund abuses. The Committee heard from Securities and Exchange Commission Chairman William Donaldson about the current state of affairs within the mutual fund industry; he acknowledged that market timing and late trading practices seem to be "quite widespread"--more than originally anticipated. That said, the SEC does not know how widespread the practice of market timing in fund managers' personal accounts may be. Donaldson also announced that the SEC is "very deliberately" investigating the matter, and that specific market proposals may not be made for months.

The Investment Company Institute (ICI), the industry group that represents mutual funds, also testified during the House hearing and made several recommendations to restore and reinforce investor confidence. ICI has recommended the following:

Late Trading--Require that all purchase and redemption orders be received no later than 4 p.m., when the funds set the...