Why the fund probes matter

Federated Investors Inc., manager of nearly $200 billion, reported quarterly profits modestly higher yesterday. The company also disclosed an internal investigation had dug up evidence of possible improper fund trading. Federated stock got clobbered, falling 13 percent by the end of the session.

A day earlier, Marsh & McLennan Cos., the parent firm of Putnam Investments, posted powerful quarterly earnings growth. But news was out that day about the Massachusetts Securities Division's investigation into the trading of Putnam fund shares. Marsh & McLennan stock slumped.

Are the headlines scaring investors away from money management companies? Possibly. But the market's immediate reaction tells you just how much juice is running through this third rail.

The burgeoning number of mutual fund trading investigations, driven by state regulators, now includes activities at more than 20 firms across the country. They are examining the overtly illegal practice of late trading and the merely unfair activity of market timing.

Late traders take advantage of market-moving news that occurs after the daily pricing of fund shares at 4 p.m. They connive to buy shares at that day's price, which doesn't reflect the news, submitting orders that are supposed to be subject to the next day's closing price.

Market timers take advantage of mutual funds that set prices once a day but own securities operating on a different clock. They may buy shares of an international fund on a day when the US market is booming in a rally sure to lift the value of foreign stocks when their markets reopen. They can grab the quick profit and jump out of the fund again.

The great outrage that runs through most of these cases cuts to the heart of the mutual fund ethos. Quick-buck traders were allowed to profit at the expense of long-term investors. Fund companies rolled over, looked the other way, or just failed to defend the principles that are the basis for their very existence.

Putnam seems most likely to achieve the dubious distinction of becoming the first mutual fund firm to be charged with wrongdoing in the sweep of investigations. Regulators say they expect to charge Putnam with civil fraud for essentially saying one thing (prohibiting market timing in fund prospectuses) and doing another (allowing participants in some retirement funds to do exactly that). Putnam denies any wrongdoing.

Beyond the compromised principles, there is a real dollars-and-cents cost to late trading and market timing that comes out of the average shareholder's pocket. Traders are taking a slice of everyone's profits when they pile into a fund and jump back out with the gain. A few pennies, a dime or more per share. It adds up.

There are other costs too, much harder to measure. I spent a day examining investment performance, brokerage commissions paid, and cash positions of the Putnam International Capital Opportunities Fund, a favorite of some market timers, during periods I believe fund sales data suggest unusual activity.

I can't say there was clear proof in those numbers that market timers, sending cash in and pulling it out quickly, affected the performance of the fund's portfolio. But in most cases, the other hidden costs are real.

To get the real story, subpoenas help. Fortunately there are lots of them flying around.

Steven Syre is a Globe columnist. He can be reached at syre@globe.com.