Just when it looked like all those scandals were behind us and the markets were helping mend fences with leery clients, the business has gotten yet another black eye. This time, the problem is with mutual funds — more precisely how favored traders have been able to get trading profits that the retail client cannot.

In early September, New York Attorney General Eliot Spitzer and the SEC announced a sweeping probe into market timing and late trading of mutual funds. The story broke on the news that hedge fund Canary Capital Partners would pay a $40 million fine to settle charges that it traded in funds after the close and profited at the expense of other fund shareholders. The investigation quickly claimed a big-shot broker and two execs at Bank of America and tarnished the names of large fund families, including Janus, Strong and Banc One Funds. Further, regulators have announced investigations into Prudential Securities (now part of Wachovia) for trading violations.

Brokers of all stripes are angry about the news, and not just those selling to the mom-and-pops of the world. “I think there's going to be a huge fallout. I feel like my clients in those funds are entitled to some kind of piece of that $40 million,” says Carol Rogers of Rogers & Co./Wachovia Securities in St. Louis. “The money comes out of the pockets of all those investors in that fund group.”

Top producers at several firms believe this is the tip of the iceberg, and that it's going to be an ongoing headache for them and their clients. The investigation is looking at both illegal late trading — which one hedge fund manager called “insider trading, plain and simple” — and market timing, which is not illegal.

A study by Stanford Graduate School of Business professor Eric Zitzewitz done in September indicated that the late-trading phenomenon isn't limited to a few funds. It showed “statistically significant evidence” of late trading in international funds in 15 of 50 fund families (which were not named in his report).

“Oh, it's going to get a lot bigger,” says one fund executive, who asked not to be identified. “Right now, the response from reps and clients has been muted. And that's partly due to how complicated the issues are.”

That muted response, however, may not last. Brokers interviewed say the scandal suggests to clients that the system itself is troubled, and “clean” brokers will have to speak out to correct that misperception. What gets brokers so angry about this scandal — compared with the IPO and research scandals of 2002 and 2001 — is that it strikes at a product whose integrity has seldom been questioned and is the cornerstone of hundreds of thousands of brokerage accounts. Mutual funds are a $7 trillion industry, and even brokers who manage their clients portfolio on discretion use them for diversification purposes — and many independent advisors work almost exclusively with funds. “They're violating a basic tenet — they're supposed to be for the regular investor and they're supposed to be for the long-term,” says one Morgan Stanley broker.

Zitzewitz's study places the cost of late trading at about $400 million a year and estimates that market timing potentially shaves a point or two from shareholder returns. That may not seem like much, but it's something that should not be happening at all.

The practice of late trading is at odds with the very nature of mutual funds, which have been marketed as an ideal long-term investment vehicle for ordinary investors. By pooling their investments, they have been told, they gain the benefits of precise asset-allocation and professional money management that they could not achieve by buying individual stocks. They have been the ultimate egalitarian product — used not just by small investors but also by wealthier individuals and institutions. Some 87 percent of mutual fund shares are sold through investment advisors, making them a critical product for reps and planners.

Now, advisors are likely to face some uncomfortable questions. “The clients who are in the funds as long-term investors are paying with their teeth,” says Jeffrey Gerson, a Smith Barney advisor in New York. Late trading hurts investors, simply put, because the investor committing the illegal act is getting that day's net asset value of the fund — after the fund has closed for the day. “You have people who exploit these things, and blow it up for everybody; 99.9 percent of clients don't do this.”

Though market timing is not in the same category legally as after-the-close trading, it is still likely to attract scrutiny in the coming months. Shortly after the announcement of the Spitzer investigations, Wachovia Securities told brokers that an existing policy prohibiting market timing would be extended to its newly acquired Prudential brokers. Sources at the former Pru say the policy includes prohibitions against brokers to trade a client out of a particular fund more than three times a year.

That will only address part of the problem. Unless institutional holders play by the same rules, reps say, the confidence of small clients may not be easily restored. “What's happening is that fund companies are allowing it to go on because it's more money into their funds, but that's not what they're designed to do,” says Robert Rabinowitz, chief administrative officer at Montauk Financial in Red Bank, N.J. “It's against what's in the prospectus.”