Investor habits likely will change

The mutual fund business is remarkably resilient, attracting investment dollars in good times and bad. The question the industry is grappling with now is: Will the spreading scandal break investors of the mutual fund habit or will those investors be more selective and just punish the firms caught up in the misdeeds?

Like the wildfires in California, the scandal, which started small, is spreading rapidly, claiming more victims as it goes. Its highest profile victim, Putnam chief executive Lawrence Lasser resigned yesterday, less than a week after Massachusetts regulators charged that Boston-based Putnam allowed some of its money managers to trade in and out of its mutual funds. Richard Strong, chairman of Strong Mutual Funds in Wisconsin, stepped down Sunday after allegations he personally made improper trades in his firm's mutual funds.

In Washington yesterday, regulators and senators took turns blasting the industry. Republican Senator Peter Fitzgerald of Illinois described mutual funds as a "$7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation's household, college and retirement savings." Perhaps worse for the industry, state and federal regulators strongly hinted that their investigations could turn up more wrongdoing. One of those regulators, New York Attorney General Eliot Spitzer, recently said he plans charges against at least 10 more people and firms.

"We can't tell yet whether these are isolated incidents or whether this is something that is going to shake the foundation of the industry," said Geoff Bobroff, a mutual fund consultant in Rhode Island. The fallout from the scandal matters to Boston, which is home to four of the nation's 25 largest mutual fund families. Putnam, with $139 billion in assets, is the country's fifth largest mutual fund complex.

Most of the targeted mutual funds, including Putnam, have been accused of allowing big investors to engage in market timing, rapid-fire trading of funds that lowers returns for other investors. The practice, while not illegal, is specifically outlawed in most mutual fund prospectuses.

Historically, the mutual fund industry has weathered tough times well. In 2001 and 2002, two very poor years for the market, Americans put $254 billion into funds, according to Boston's Financial Research Corp. In the first nine months of this year another $161 billion was invested. "Where else are investors going to turn?" said Jonathan Pond, a financial planner based in Watertown.

But as Pond and others said yesterday, investors make distinctions among mutual fund families. Putnam is a good example. While the firms' funds performed well during the bull market of the late 1990s, those same funds performed poorly when the market fell in 2000, 2001 and 2002. Investors reacted by voting with their feet. They withdrew money from Putnam funds last year and they are doing so again this year, even though Putnam's performance has been better lately. Through September, investors withdrew $8.8 billion from Putnam. Two other fund families that went through the same peaks and valleys, Janus Capital Management and AIM Distributors, also experienced outflows.

Industry watchers yesterday predicted that mutual fund firms that get tarred in the current scandal will see money go out the door. The problem with that forecast is that no one knows which other firms may face accusations in the coming days. Investors who move money quickly may find they have traded one problem for another.

Even so, Burt Greenwald, a mutual fund consultant based in Philadelphia, said he expected to see redemptions at firms such as Putnam. "And I don't think they will succeed in attracting new money," said Greenwald. "How would you like to be a broker selling a Putnam fund?"

Like many mutual fund companies, Putnam relies on middlemen such as brokers and financial planners to sell its funds. Those middlemen can steer money toward some firms and away from others.

Another key set of middlemen are the companies that sponsor 401(k) retirement plans for employees. Edward Lynch, a money manager based in Newburyport, yesterday said that some 401(k) plans he knows have been contacted by brokers looking to move money out of fund families accused of wrongdoing.

Daniel Weiner said some mutual fund familes could benefit from the adverse publicity. Weiner is president of Adviser Investment Management in Watertown, which manages $425 million in Fidelity and Vanguard funds. Neither Fidelity Investments nor Vanguard Group has been accused of any misdeeds so far. "The companies that keep their noses clean may be seen as bastions of solidity," said Weiner.

Charles Stein can be reached at stein@globe.com.