Evaluating Scandal-Tainted Fund Firms

At this point in the market-timing scandal, a number of fund companies have been implicated in one form of wrongdoing or another. The SEC says that half of all fund companies appear to have had some kind of market-timing arrangements. It's a sad statement that so many firms would play fast and loose with their fiduciary duties.  

At Morningstar, we will review each case of potential wrongdoing individually, applying a consistent set of standards. We'll advise you as we would our friends or relatives. When companies step out of line, we'll call them on it, but our recommendation to you will be based on our assessment of the funds' prospects.

Our Evaluation Criteria
We'll evaluate fund companies by two criteria. First, we'll examine the evidence of wrongdoing and unethical behavior. Specifically, we'll consider how widespread the activity was, how high up it went, and how serious the actions were.

Second, we'll review this new information in light of the quality of management and corporate governance standards we've always examined. The key measures are:

• How investors have done in the firm's funds
• Fund costs
• Whether the firm launches new funds responsibly
• The experience, skill, and integrity of management 
• The clarity of communication with shareholders 
• Internal compliance and risk controls

When there is strong evidence of serious wrongdoing, the quality measures will determine our advice. If a firm scores poorly on most of those measures, we will recommend that investors consider selling the firm's funds. If it has a mixed record, we will recommend that investors limit their investments in the shop to a small portion of their portfolios. If the firm scores well on the governance/quality measures, we won't recommend firmwide action.

Monitoring Firms on Our 'Consider Selling' List
For those firms on our "consider selling" list, we need to see, first and foremost, that the individuals who behaved unethically and any superiors who approved their actions have been removed from the company. A public statement to that effect will be a strong signal that the fund firm is setting out on a new path.

Second, we want to see steps taken to ensure that gaps in compliance and ethics policies have been patched, so the incidents can't be repeated. Adding redemption fees, or boosting those already in place, and strengthening fair-value pricing are tangible signs of progress. We'd also like to see other signs that the firm is shifting its corporate culture to put fund investors first.

As firms begin to meet these hurdles, we will consider moving them from the "consider selling" list. Even after the firms come off the list, however, we'll continue to monitor how well they follow through on their plans to put fund investors first. Further, we'll always be open to new evidence, both good and bad, that could change our opinion.

Our Goal
At the end of the day, we want to be sure that we're recommending only funds with an attractive risk/reward profile, and that includes weighing compliance and other ethical risks, as well as the more straightforward investment risks associated with their objectives and strategies.

This is an updated version of an article that appeared Sept. 18, 2003.