The nation's $7 trillion mutual fund industry is at the center of an illegal trading scandal that threatens to further alienate small investors.

Several mutual fund firms, investment banks and hedge funds have been implicated in 'market timing' and illegal late trading of mutual fund shares. These practices have benefited an elite group of investors and fund managers at the expense of millions of small investors.

The US Securities and Exchange Commission (SEC) and state regulators in New York and Massachusetts have brought charges against such firms as the mutual fund giant Putnam Investments, the brokerage firm Prudential Securities and a series of smaller mutual fund companies. Individual brokers and executives at some of these firms are facing criminal charges, while the mutual funds themselves face civil fraud charges.

Congressional hearings are currently being held, and new charges continue to surface. What started as a settlement with a single hedge fund has expanded to encompass large sections of the mutual fund industry.

The charges concern manipulations made possible by the peculiar way in which mutual funds are priced. A mutual fund firm invests in a broad range of stocks or other securities on behalf of a large number of individual clients, often small investors who purchase mutual fund shares through retirement plans or other savings. The mutual fund was devised as a means of bringing small investors into the market. It allows the small investor to diversify holdings (and thereby decrease risk) by creating a vehicle for a small amount of capital to be invested in a large number of different securities.

Mutual funds are not priced continuously on the market. Rather, at the end of each trading day (4 p.m. Eastern Standard Time), the total value of the fund's investments is calculated and this figure is divided by the number of outstanding fund shares, yielding the price per share. An order to buy or sell a share in a mutual fund is held until the end of the day, when it is processed at the closing price. This pricing policy tends to discourage short-term trading of fund shares, since investors are generally unable to take advantage of temporary fluctuations in the price of the underlying assets.

This has not, however, prevented insiders and wealthy investors from finding ways to exploit the pricing mechanism of mutual funds to their own advantage. One of the ways highlighted by the current charges is known as market-timing.

In market-timing, an investor takes advantage of the fact that the price of a mutual fund is determined by the closing value of the shares owned by the fund, regardless of when this closing value was set. International stocks owned by the fund are priced at the value of the stock at the time of the closing of the market in which they are traded, which can be hours before the closing of the American markets. It is this 'stale' value that determines the transaction price of the mutual fund share, even though in the intervening time (between the closing of the foreign market and 4 p.m. EST) events may have occurred that lead investors to conclude that the actual value of the foreign shares is different from its closing value.

The real value of the mutual fund is therefore different from the calculated value at the close of the US trading day, providing an avenue for savvy investors-especially those with inside information-to make an easy profit.

Not only do such practices provide a windfall for an elite group of investors; they also negatively affect the savings of millions of ordinary mutual fund investors. Any time an investor sells at a price above the true market value of the fund's shares or buys at a price below the market value, the difference must be absorbed by the mutual fund itself. For example, the fund may have to pay an investor selling his shares more than the actual value of the share. This means that the total value of the assets owned by the fund-and therefore the holdings of each individual shareholder-must go down.

In his testimony before the Senate Governmental Affairs subcommittee on November 3, New York attorney general Eliot Spitzer quoted the Financial Analysts Journal : 'Because the gains [of market timers] are offset by losses to other investors in the fund, the funds clearly have a fiduciary duty to take some preventative action. All the gains are being offset, dollar-for-dollar, by losses incurred by buy-and-hold investors.' The same applies for late traders.

Moreover, the extra transactions require the funds to buy and sell shares in their own holdings more frequently, thereby increasing transaction costs to the firms, which must again be deducted from the value of their shares.

This type of illegal or fraudulent activity has generally been carried out on behalf of hedge funds, which are investment vehicles restricted to wealthy individuals. In a few instances, managers or brokers have benefited personally by engaging in these trades.

In his testimony before the same Senate subcommittee on November 3, Stephen M. Cutler, the director of enforcement for the Securities and Exchange Commission, stated that more than a quarter of major brokerage firms examined by the agency had allowed some big investors to trade late. Cutler also said the SEC had examined the records of 34 brokerage firms and found that almost 30 percent had helped some investors perform market-timing trades. He added that more than 30 percent of brokerage firms had disclosed information about their portfolios in a manner that would give select customers an advantage.