Morningstar Cautions Investors in Wake of Canary Scandal

In a series of scathing analyses posted to its  Web site , Morningstar blasted Bank of America, Janus, Strong, and Bank One over the allegations of trading misdeeds leveled by New York State Attorney General Eliot Spitzer and said shareholders should consider heading for the exits in all four cases.

Spitzer has contended that units of those fund families agreed to give hedge fund Canary Capital Partners LLP manager Edward Stern preferential treatment by allowing Stern to buy and sell fund shares at prices not available to other investors.

None of the fund companies have been charged with any wrongdoing, however two types of trading violations have been tagged “fraudulent” by the  Spitzer complaint :  Late trading, or buying mutual-fund shares after the market close at that day’s closing price; and timing, which involves taking advantage of market-moving events after the close of the market, when the funds’ daily price is set based on the net-asset value of the portfolio. (See   Spitzer Fund Abuse Probe Pumps Out More Subpoenas ).

But Morningstar by far reserved its harshest blast for Janus, with a strongly worded  commentary by analyst Brian Portnoy charging that Janus put its own profitability ahead of the interests of investors in its funds. Portnoy also cited poor performance of Janus funds in the bear market and a string of management departures – the combination of which constituted “three strikes” against the Denver-based fund.

Getting Out

As a result, Portnoy not only recommended that investors skip over Janus’ in-house funds but that those already with a position in those funds seriously consider getting rid of it.

“We think that the Janus fund family does not deserve investors’ confidence,” Portnoy wrote. “As has been splashed across the financial press over the past week, Janus, in addition to several other prominent asset managers, has been implicated in what is arguably the mutual fund industry’s worst scandal ever. What has soured our stomachs with Janus in particular is that the firm already had two major strikes against it: poor bear-market performance and noteworthy management departures. This ethical breach is the third strike against it. Three strikes, you’re out.”

If the fund company is willing to own up and make shareholders whole, Portnoy said Morningstar would once again consider putting certain Janus funds back on its recommended lineups. “When Janus cleans out the bad apples and pursues a myriad of other remedies to both pay back shareholders and rebuild a culture of integrity, we will consider recommending certain Janus funds once again.,” the analyst said (he also noted that this recommendation does not affect the Morninstar star ratings of the funds, which “are a purely quantitative measure of risk and return”).

However, Morningstar’s Christine Benz cautioned investors in a separate  commentary  about overreacting to the Canary scandal.   “This news, though dismaying, shouldn’t undermine investors’ trust in mutual funds as a whole,” wrote Benz. “Many fund shops – from behemoths like Vanguard and Fidelity to boutiques such as Davis/Selected Advisors and Longleaf Partners – have long histories of putting shareholders first. We continue to believe that mutual funds run by such shareholder-friendly firms represent worthwhile investment opportunities for most investors.”

A Phoenix-based trustee/custodian also named in the Spitzer investigation recently fired back with an announcement that it’s own in-house showed that trades it handled for Canary didn’t harm any of its other customers (See   STC: Canary Trades Didn’t Harm Other Clients).