Morningstar ripped into Federated Investors and Fremont Investment Advisors last week, urging investors to avoid sending new money to the shops, only later to shy away from specific criticisms it had levied, but maintaining its recommendation.

The advice came in the form of a "Fund Spy" column, written by the Chicago fund-tracker's Director of Fund Analysis Russ Kinnel and distributed via an e-mail service and posted on the company's Web site. In the original article, Kinnel offered a scathing indictment of Federated and Fremont for keeping the public mostly in the dark about both wrongdoing and remedies at the firms. He asserted that the firms have leaked information in dribs and drabs, revealing very little, in an attempt to stay out of the headlines, a claim that is absent from the revised copy.

"We wouldn't send [either firm] a dime until they've settled with regulators and made clear how they've rebuilt their compliance systems and righted their listing corporate cultures," Kinnel wrote in the original article. "We'd like to be reassured that all the necessary steps have been taken to protect shareholders from bad dealings, but neither has given the public much information on the subject at all," Kinnel wrote in a passage that was later removed. "Federated has a lot to answer for, but it seems it would prefer not to," Kinnel penned in a section that was extracted as well.

Also gone from the copy is his characterization of problems at Federated as a "huge breakdown in compliance," which he later described as "mundane but still serious market timing at Federated and Fremont." The first time around, Kinnel said the compliance breakdown at Federated was rivaled only by activities at the notorious Nations Funds and Columbia Funds, both now owned by Bank of America.

Federated had market-timing deals in place in exchange for sticky assets, and late trading did occur at the firm, although Federated characterizes it as accidental. The firm hasn't disclosed whether senior management was aware of, or approved, the timing deals, Kinnel notes. It had also stopped monitoring frequent trading activity for its institutional clients for several months starting in the spring of 2003, a wrinkle that Kinnel said led him to update his article. In his previous story, the monitoring lapse didn't include the fact that the firm continued to monitor retail investors during that period.

"The key point was that I learned that it wasn't a complete lack of trade monitoring," Kinnel said. "It was just on the institutional side only. That led me to make some changes and update it, but it didn't change our basic recommendation. A big part of my point initially was the lack of information, so the greater detail they provided on the trading monitoring changed my view a bit on how great a compliance gap there had been."

Roy Weitz, industry critic and publisher of FundAlarm.com, said that even if the error was only on the institutional side at Federated, the lapse is still a massive breakdown. "Institutional includes hedge funds, and that's where everyone knew the problems were."

Weitz said the distinction is not a huge development and certainly not a reason for a major change in thinking in the Federated case. "They knew very well what they were doing. It doesn't let them off the hook, in my opinion." He also said that if it was selectively done just to allow institutional clients to rapid trade, that is worse because they had the capability to monitor and chose not to.

Federated said it has, in fact, discussed the issues raised in the article with Morningstar and issued an "extensive" press release addressing the investigations in November and another in February pertaining to "a thorough set of remedial actions" the firm is undertaking. Those include outsourcing the firm's transfer agency business as well as the establishment of a $7.6 million restoration fund. "There's nothing new here," said J.T. Tuskan, director of marketing at Federated. "Morningstar continues to raise the same points, and we disagree with their opinions."

As for Fremont, the firm entered into timing deals, but the details are sketchy, as the firm has been mum with the exception of one statement posted on its Web site that was simply updated with a few paragraphs once more revelations surfaced, according to Kinnel's article. He said it's "encouraging" that those responsible for the timing at Fremont have been expelled from the firm, but Morningstar will have "greater certainty when regulators have signed off on those remaining at the funds." However, Kinnel added that it is "disappointing" that investors in funds subjected to frequent trading and potentially late trading have not been informed.

Pat Harden, a spokeswoman for Fremont, said there are facts that were dismissed as inconsequential by Morningstar or omitted entirely, that are important. The firm has disclosed all regulatory actions to shareholders and on the Web site. It has also posted a statement outlining steps to reinforce policies and procedures relating to market timing, Harden said. Fremont has also agreed to fairly compensate fund shareholders for losses attributed to excessive short-term trading and rebate advisory fees attributable to excessive short-term trading investments to the funds.

When Morningstar Talks . . .

Throughout the scandal, Morningstar has been a vocal critic of funds that have misbehaved, often recommending that investors consider selling, avoid sending new money to a firm, or advising to proceed with caution. It has made recommendations on 21 fund shops thus far. It is nearly impossible to gauge the impact a negative recommendation can have on a firm's business, but some firms consider the advice a serious matter since Morningstar has such a wide reach. Morningstar declined to comment on the number of readers who receive its e-mail service, but Morningstar.com has more than 2.7 million registered users and an additional 120,000 paid subscribers. The firm said its individual investor Web sites have more than 2.9 million registered users worldwide and its print publications reach about 200,000 additional individuals. It also claims to reach about 100,000 financial advisors.

"What our shareholders and our fund investors are looking at is important to us," said Jane Ingalls, a spokeswoman for Janus, which was bumped up to "proceed with caution," the tamest of the three recommendations, in May. "Obviously, Morningstar has a big impact with fund investors, and they're viewed as a very important rating agency of mutual funds."

Whether it's hurt asset flows or damaged reputations, firms are concerned. Julie Crothers, a spokeswoman for Bank One, explained that at her firm, "it was more of an image concern than a business concern because of the way most of our funds are sold."

While Kinnel explained some of the reasons for the changes, others are not so clear, such as why he would delete harsh language discouraging sending money to the firms when, in fact, that is still his recommendation, or why he would omit stern language about wanting more information from Federated, when there still are many questions and concerns about the goings on at the firm. Weitz theorized that the revision may be tied to Morningstar's impending IPO and the firm's wishes for few problems in the time leading up to the event. As for Kinnel, he said there are no plans for a correction or to specifically alert readers to the change, especially since the overall recommendation remains intact.

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