FOR FUND INVESTORS, IT’S NERVOUS TIME : Mutual Funds: Whiffs of scandal raise questions about a trusted industry. The key is knowing what to worry about.

A star stock mutual fund manager is fired for failing to report personal stock transactions.

One of the fastest-growing fund companies admits that it is under Securities and Exchange Commission investigation for improper in-house trading.

State securities regulators charge that banks are selling funds without adequately explaining the risks to buyers.

Could this be the same squeaky-clean mutual fund industry that 38 million Americans have come to know so well--and to entrust with $2 trillion of their savings?

It is, of course. And if the question is whether the average fund shareholder needs to worry about recent headlines that suggest fraud and abuse, the answer is yes.

But investors’ concerns should be focused in the right place, fund industry critics say. Thanks to the complex legal structure of funds, the risk of outright theft or willful abuse of your money at the hands of faraway portfolio managers remains extraordinarily low.

The real issue is whether, after three years of unprecedented growth in fund assets, the improprieties now surfacing suggest a breakdown in the industry- and government-sponsored policing efforts that have kept mutual funds remarkably scandal-free for more than a half century.

Even if that policing indeed has grown lax, the potential cost to your fund is likely to be measured in nickels and dimes, experts say--higher portfolio costs from botched trades, for example, or losses on mispriced securities.

But nickels and dimes add up over time; it’s like someone’s stealing from you on an installment plan.

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Fifty-four years ago, the federal government put the mutual fund business on a leash so tight that it might have strangled the funds. Instead, federal oversight for decades has protected the industry from the wrongdoing that’s occasionally wreaked havoc on other financial service industries.

Mutual funds aren’t covered by any form of government insurance--unlike the deposits, say, of the savings and loan industry, which Uncle Sam guaranteed even as white-collar bandits openly looted scores of S&Ls; nationwide in the 1980s.

But precisely to shelter the funds from that kind of brazen fraud, unparalleled structural safeguards have been built into the industry.

Most important is a series of federally mandated checks and balances that govern how fund shareholders’ money is received, invested and held--and the requirement that every fund make extensive, regular reports to its shareholders.

“No other financial industry requires so much disclosure to shareholders of what’s going on with their money,” says Joel M. Dickson, a Stanford University economist and fund expert.

Most of these safeguards were hammered out in 1940, in a landmark piece of legislation called the Investment Company Act.

Until then, the federal government had left the details of regulating business mostly to the states, notes Harvey Pitt, an attorney at Fried, Frank, Harris Shriver & Jacobson in New York and a former SEC official.

“In 1940,” he says, “Congress said the one exception would be mutual funds.”

At that point, the funds were a $1-billion business. And to the surprise of many observers of that day, rather than fight federal oversight, the fund industry endorsed it.

The industry’s acquiescence had a lot to do with its roots. The mutual fund was born in 1924 with the creation of Massachusetts Investors Trust--the product, like many of the funds that followed it, of Boston Brahmin money men whose upbringing and conduct defined the terms proper and prudent.

The big idea behind mutual funds was that investors could pool their money and name trustees to manage it. It was a populist expansion of the original trustee concept that had solved the problem of 19th Century Boston ship captains, who needed someone to look after their assets while they were away for months at sea.

When a Depression-weary Congress decided that fund investors needed better protection against potentially unscrupulous operators, the Brahmins had no reason to disagree. Keeping the industry clean, after all, was the best way to keep money flowing in.

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Consider the typical fund transaction today: Mrs. Garcia in Los Angeles writes a check for $1,000 to Stock Fund X, based 3,000 miles away.

Garcia has never met with anyone from Fund X. She learned about the fund from a friend or an ad. Her dealings with the company have been exclusively by phone or mail. She received a document, the fund prospectus, before she invested. But like most fund shareholders, she didn’t read it all.

Instead, Garcia accepts on faith that the fund is a legitimate investment and that she’ll be treated fairly--whatever that might mean.

What she probably doesn’t realize is that her fund, by itself, is nothing but a shell. It has no employees of its own. It exists only on paper.

How could this be?

Under the Investment Company Act, a fund is required to contract with others, at negotiated fees, for the various services it needs performed. Some of the providers may be part of the same umbrella company (like, say, giant Fidelity Investments), but others are almost always outsiders.

In other words, what Garcia has purchased with her investment is a stake in an asset pool serviced by a series of contractors.

Fund X’s “transfer agent,” for example, is the first stop for Garcia’s investment. The transfer agent records and processes shareholder accounts and handles other aspects of shareholder communications.

The agent transfers the money not to the fund’s portfolio manager (the individual or firm that makes the investment decisions, technically known as the “investment adviser”), but to the “custodian,” usually an independent bank.

Indeed, the act’s requirement of independent custody for each fund’s assets is the key provision that has sheltered the industry from potential trouble for half a century.

In effect, separate custody means a fund’s parent company can go belly-up without any loss to the fund’s shareholders, because their assets are held apart from other funds’ and from the parent’s.

Moreover, although the fund manager decides how to invest shareholders’ money, it’s the custodian who controls the underlying securities, allowing them to be traded or exchanged with other institutional investors only after getting proper documentation from the manager.

The upshot of independent custody is that “it’s very hard for a fund manager to take the money and leave,” says Stanford’s Dickson.

Contrast that with the far less restrictive set-up between individual investors and their bankers or stockbrokers, who have direct access to clients’ accounts--and who, in any number of notorious incidents, have taken the money and run.

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The Investment Company Act adds other layers of investor protection as well.

Independent accountants must regularly audit every fund; a fund’s board of directors, the modern-day trustees, are supposed to negotiate prudent contract terms with the fund’s service providers and generally oversee the operation; and the SEC has the power to inspect funds and bring enforcement action against those that break the rules.

But if these many safeguards are working, why the recent headlines suggesting that all is not well?

The devil, as usual, is in the details. The funds’ extensive disclosure of what they do is one thing; compliance with the rules is another.

In part, the industry may have become a victim of its own success.

There are 4,600 funds today, nearly 2,000 of which have been created since 1990. Never have the funds hired so many new people in so short a time. Never have so many young, untested, portfolio managers been entrusted with so many hundreds of billions of dollars from mom-and-pop investors.

And, by many accounts, never has the SEC been so woefully understaffed to perform its all-important watchdog function.

Barry Barbash, the current chief of the SEC’s investment management division, concedes that with just 150 examiners nationwide to watch $2 trillion in assets--up from $1 trillion just three years ago--the SEC’s oversight is limited.

“We can’t be relied upon for compliance,” he says flatly. “The funds have to be interested in it.”

No one, including Barbash, questions that the majority of fund companies are interested in compliance. At giant firms like Fidelity, legions of compliance lawyers--essentially, in-house cops--are paid to make sure that portfolio managers, traders and others follow the rules.

Even so, two of the most disturbing controversies to rock the industry this year suggest major gaps in in-house policing.

* On Jan. 4, Denver-based Invesco Funds fired star manager John Kaweske after he admitted making a string of personal trades last year without properly notifying the company.

Under SEC rules, funds are required to have codes of conduct for managers. The codes require advance reporting of personal securities transactions so that there can be no conflict of interest between a manager’s personal trades and what he does with his fund’s securities.

The obvious worry: A manager could “front-run” his own fund, personally buying or selling securities before the fund trades in them--to his gain and, possibly, the fund’s loss.

Invesco says it has no evidence that Kaweske engaged in front-running, and he denies any wrongdoing.

But another Kaweske surprise was perhaps more startling, other fund-company executives concede: Invesco says it did not know that Kaweske had signed on as a director of ID Biomedical Corp., a small company in which one of his Invesco funds had invested.

* Earlier this month, Strong Funds, a fast-growing Milwaukee-based organization, revealed that the SEC is probing in-house trades between individual Strong funds from 1987 to 1990.

To avoid the potential for self-dealing--that is, favoring one fund at the expense of another--the SEC sets down strict guidelines when funds in the same company trade a security between one another rather than on the open market.

Richard Strong, the firm’s founder, insisted in a March 11 memo to employees that the SEC hasn’t alleged a self-dealing problem. Instead, he said, the probe focuses on whether in-houses trades were conducted according to SEC rules “and whether the firm’s disclosures accurately describe its trading policy.”

Trying to explain how the firm might have slipped in the late 1980s, Strong reminds employees in the memo that “we didn’t have even one lawyer on staff in 1990”--though the company’s fund assets were already $1.4 billion by that point.

Therein lies the great fear of the SEC’s Barbash, other regulators and most of the major fund companies:

How many of the scores of fund organizations born in recent years, they worry, are growing faster than the house cops can handle? How many nickels and dimes might that ultimately cost shareholders in front-running, questionable trades or even more serious offenses?

Says Barbash: “What concerns me is the number of new entrants into the business . . . who don’t come in with that culture of the (Investment Company) Act built in”--that Brahmin culture of prudence and conservatism.

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Some fund industry critics say the problems go much deeper.

Don Phillips, publisher of independent fund-tracker Morningstar Inc. in Chicago, believes there has been a gradual erosion of fund directors’ oversight, minimizing their ability to act as proper trustees.

“The Investment Company Act went out of its way to emphasize that shareholders were the owners of a fund and that the directors worked for the shareholders,” Phillips says.

Today, he and other critics argue, many directors’ loyalties are skewed more toward the funds’ investment advisers, who generally pick the directors in the first place, than toward shareholders’ best interests.

If the directors really were watching the funds, critics ask, would they be standing idly by as state securities regulators charge that banks are selling fund shares to people who have no clue about the market risk involved? Is that the kind of customer a director really wants?

Where directors’ biases are most obvious, critics say, is in the issue of management and marketing fees charged by fund investment advisers--the typical 1% to 3% of fund assets taken from shareholders each year as the major cost of running and promoting the fund.

Jack Bogle, head of the Vanguard Group of funds and an outspoken critic of fund fee levels, contends that “directors are a big part of the problem . . . They don’t seem to realize that they have to stand up and take a more active role” in negotiating lower fees so that shareholders keep more of their own money.

Why more fund shareholders don’t vote with their feet also mystifies the experts. Say two bond funds earn the same annual return of 7%--an optimistic expectation this year. One racks up expenses of 0.5% of assets; the other’s expenses total 1.8% of assets.

Do the math: The owner of the low-cost fund takes home 6.5%; the high-fee fund shareholder earns just 5.2%.

The debate, of course, isn’t one-sided. Many shareholders whose fund managers deliver excellent performance year after year may feel that they’re getting a bargain no matter what the management fee.

What’s more, directors aren’t charged with getting the lowest possible fee, but rather a fair fee, legal experts note. And what is “fair” can be subjective.

Phillips says his point in questioning the directors’ role isn’t to suggest that shareholders would be better off in some other investment vehicle.

But as with many of the questions being raised about the funds’ self-policing abilities today, he says the best advice for investors is to know all you can about your fund--how it operates, what it owns, what it costs and what its performance is relative to other funds.

The Investment Company Act still makes it extremely difficult for a fund’s assets to be filched. But in the end, having your investment slowly chiseled away by incompetence, arrogance or borderline fraud may be only slightly less painful.