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Morningstar Dilutes Criticism of Federated

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, 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.