Probes raise many questions

Investigations into abusive trading practices at mutual fund companies have led to resignations, dismissals, and charges of fraud at top mutual fund houses, including Putnam Investments in Boston. Yesterday, at least four government agencies in Massachusetts pulled billions of retirement dollars out of Putnam. But many individual investors are still trying to understand the allegations and figure out what to do with their money. Some questions they might be asking about their own mutual funds:

What are late trading and market timing?

Both stem from the fact that mutual funds set their prices once a day, usually at the 4 p.m. market close. Prices of the stocks and bonds inside the fund trade all day long. That disparity sometimes creates opportunities for people to make low-risk profits for themselves -- generally, though, in ways that can hurt the fund's less-active investors.

Late trading is the easiest to explain. Big-money investors are sometimes allowed to trade after 4 p.m., but still get credit as if they had made the trades prior to the market close. This is a clear violation of securities laws, both by the broker and the fund companies.

"Let's say a group of companies announce earnings at 5 that are wildly better than expected," said Michael Goldstein, a professor of finance at Babson College. "You might be almost positive that the market will be up 20 percent at the open tomorrow morning. So for you to make a fund trade that night and still get credit for the earlier price means you can be almost positive of guaranteeing a 20 percent gain for yourself."

Market timing is similar, except that the trades are made late in the trading session, usually just before the 4 p.m. market close. It's not illegal, but it breaks covenants most funds make in their prospectuses that theoretically keep the practice in check.

Market timing is usually done in international funds. It's easiest there, because overseas markets close earlier than US markets, creating an opportunity to game the system.

The Frankfurt Stock Exchange closes six hours ahead of the New York Stock Exchange, for instance. An investor in a US mutual fund heavy with German stocks knows what the country's DAX index did that day long before the end of the trading session in New York. That, compounded by the fact that six more hours of American trading are likely to have an impact in Europe the next day, can give an investor a good idea about which direction the Frankfurt market is likely to move at the open tomorrow.

Why should individual investors care?

For one thing, rapid trading generates trading commissions and other costs that everyone pays, while the rapid trading benefits only a few. For another, keeping excess cash on hand to deal with large movements in and out of a fund can also tie fund managers' hands and prevent them from investing the money as they'd like.

How do I know if my fund company allows this sort of thing?

Most likely, you can't -- unless your fund has been nabbed by regulators. But check your fund company's prospectuses to see if they have specific language about how they stop or limit market timing. (Late trading, remember, is outright illegal.) A few fund companies, such as Rydex, allow it. Most limit the practice.

OK, but what should I do if I happen to invest in one like Putnam or Janus, which have been implicated?

The answer depends on how you own the funds, whether you can sell your shares without triggering serious tax consequences or redemption fees, and what your alternatives are.

Goldstein, though, is unequivocal. "If you found out your plumber or mechanic was ripping you off, you'd probably change plumbers or mechanics," said the Babson professor. "Why wouldn't you do the same with your mutual fund?"

Fingerman said several clients have called him with questions about Putnam in the past week.

"I told them I don't really think it's time to panic, but if the floodgates open and people start taking their money out in droves, it could be bad for the Putnams of the world," he said. "If you have a lot of money there, I would definitely consider moving some of it out."

Scott Bernard Nelson can be reached at nelson@globe.com.