Federal and state regulators have begun investigating more than a dozen mutual fund companies for allegedly allowing questionable investment practices. City and county finance officials are grappling with a host of issues raised by the investigations, including whether to pull employee retirement money out of mutual funds that have come under scrutiny and, if so, where to invest that money. The issue is complicated by the possibility that the scandal will widen beyond the companies now being investigated.

By mid-November, 14 companies — such as Putnam Investments, Morgan Stanley and Janus Capital — had fallen under scrutiny for various alleged abuses, including allowing favored shareholders to engage in late trading and market timing. Mutual funds under management by the involved firms have been valued at more than $1 trillion.

Late trading, which is illegal, means buying or selling mutual fund shares using that day's closing price after the stock market has closed for the day. Those buy and sell orders should receive the next day's price. Thus, if the share prices went up the next day, the preferred investors could have sold their shares for a profit, which would diminish the returns of other investors.

Market timing entails the rapid trading of shares to take advantage of short-term market swings. While the practice is not illegal, most funds do not permit the technique because it decreases the profits of a fund's long-term shareholders.

Like many local governments, Kalamazoo, Mich., is monitoring developments closely. Kalamazoo employs 890 people and provides two types of retirement plans: a defined benefit plan with $325 million in assets and a 457 defined contribution plan with $12 million in assets. “As an employer and plan sponsor with certain fiduciary responsibilities, we have been meeting with representatives from our [plan] administrators to make sure that they are doing their due diligence,” says Finance Director Mark Stuhldreher.

According to Stuhldreher, the defined benefit money has not been invested in the mutual funds in question. However, that is not the case with the defined contribution plan. For instance, some employees in the city's 457 plan have directed portions of their contributions into one Janus and two Putnam funds offered by the Washington, D.C.-based ICMA Retirement Corp., one of two firms employed by the city to administer 457 plans.

However, ICMA Retirement Corp. has announced that, effective Dec. 19, it will eliminate the three funds from its offerings because of the investigations into the operations of both Putnam and Janus. “We will continue to monitor the funds of other investment companies that we offer to our participants,” the organization said in a press release announcing the move, later adding, “We will assist our investors in obtaining any compensation that they may be entitled to, based on improper investment activity.”

Such a move cannot completely resolve Kalamazoo's concern, however. “As the investigations continue, the problems may get broader,” Stuhldreher says. “In some funds, problems may turn out to be isolated, and it might not make sense to pull money out. They might be able to clean up their processes.”

“Then again, you don't want to be the last one to pull out of a fund,” Stuhldreher adds. “We're keeping an eye on [the situation].” So, too, are local governments across the nation.

— Michael Fickes is a Baltimore-based writer.