“Redoubling their hunt for rogue mutual-fund traders, federal fund gumshoes plan to follow the money — literally,” writes Ian McDonald in today’s Wall Street Journal.

“Amid the continuing revelations of the mutual-fund trading scandal, regulators at the Securities and Exchange Commission have been reviewing how to sharpen their oversight of the vast fund business, home to more than 8,000 portfolios holding $7.54 trillion in assets.”

“One regulatory tactic slated for greater use: to continually sift through cash-flow statistics looking for portfolios with high levels of fund shares being bought and sold. Such activity can be the hallmark of a fund being preyed upon by rapid-fire traders using techniques such as market timing and late trading that can hurt long-term investors.”

” ‘If you look at fund flows in and out, you can identify funds that are susceptible to market timing and late trading,’ said Paul Roye, director of the SEC’s investment-management division. ‘That data can help us target firms for inspection.’ “

“Market timing involves frequent buying and selling of fund shares at bargain prices because of ‘stale’ valuations of securities in a fund’s portfolio. While not illegal in itself, market timing can violate terms of a fund’s prospectus, which has resulted in fraud charges against some fund companies and their executives for allowing such kinetic trading. Late trading is an illegal practice that involves buying and selling fund shares at prices unavailable to other investors.”

“While far from a perfect divining rod for tracking questionable trading, an inspection of fund cash flows might help regulators identify trouble spots more quickly than they have in the past. The first allegations of improper share trading in the current fund-industry scandal weren’t unearthed by SEC surveillance, but instead came from tipsters who contacted the office of New York Attorney General Eliot Spitzer.”

“As the investigation expanded, federal regulators discovered that fund improper trading had gone on below their radar for years. Most mutual funds are intended to serve as long-term investment vehicles and therefore high levels of money flowing in and out of an individual mutual fund — while certainly not a definitive sign of wrongdoing — can be a red flag to regulators.”

“Take the case of Alliance Capital Management Holding LP, which, without admitting or denying wrongdoing, settled civil fraud charges involving market-timing arrangements made for its technology fund. The charges stemmed from the discovery that two Alliance officials allegedly allowed one large investor to make large and rapid trades in the fund’s shares.”

“An examination of the fund’s flow data might have raised questions about the trading activity earlier. A review by fund tracker Lipper Inc. of publicly available cash-flow data for the fund’s Class A shares found that $12 billion in shares were bought and sold in the fund’s fiscal year ended Nov. 30, 2002, a period during which the fund averaged $1.5 billion in assets.”

” ‘When you see funds with a lot heavy [cash] flows in and out, it tells you something is going on,’ says Eric Zitzewitz, a Stanford University business professor who has published several papers on market timing and its effects.”