In case you haven't noticed, Morningstar has been characterizing the mutual funds you research on its pages (or through its electronic services) as to their "stewardship," that is, how seriously those funds' managers take their responsibility to manage your clients' assets.
It took the widespread mutual fund scandals of 2003 to spawn this new service — or maybe Morningstar, being the progressive company that it is, would have conceived them anyway. In any event, the rankings add a new and valuable dimension to mutual fund analysis that advisors need to pay attention to. Remember the fancy footwork you did in 2003 explaining to clients why their money was invested with firms like Janus and Strong? You should never have to repeat that experience if you follow the "stewardship rankings" of the funds you research for inclusion in client portfolios.
In the edition of the stewardship rankings prepared as of August 29, 2006 specifically for Research magazine, Morningstar's top ten best and worst mutual fund families emerged as follows:
How are these rankings derived? Explains Laura Lutton, senior mutual fund analyst with Morningstar: "We study five components in determining our stewardship scores — regulatory issues, board quality, manager incentives, fees and corporate culture. Each component is worth a maximum of two points with an overall score of 10 possible points. With the exception of regulatory issues, the minimum score a fund can receive in each component is zero; for regulatory issues, the lowest possible score is -2."
Morningstar's scores correspond to one of the following qualitative terms: Excellent = 2 points; Good = 1.5 points; Fair = 1 point; Poor = 0.5 points; Very Poor = 0 points or fewer. "Each fund is assigned a letter grade from A to F," adds Lutton. "All funds are graded on an absolute basis. There is no 'curve.'" In short, says Lutton, the stewardship rankings try to predict whether a mutual fund is going to be a good fiduciary for its shareholders, acting with their long term interests in mind.
By digging into Morningstar's intent behind each of the five components, one comes to understand how compelling these scores are in highlighting a fund family's adherence to fiduciary principles. By "regulatory issues," Morningstar means a fund's ability, first and foremost, to stay out of trouble with regulators. Says Lutton: "We check public documents going back three years to see if a fund family has run into trouble with the SEC or Eliot Spitzer or others. If past transgressions have been serious, we look to see what these firms have done to address them in order to determine the likelihood of their having regulatory problems in the future."
Morningstar determines board quality via several variables, such as whether the chairman and board members are independent (even though not required to be by the SEC), whether the directors are investing in the funds they oversee, and whether directors have ready access to their fund managers. "Ideally, board members have invested in the funds they oversee at least the amount of their annual board compensation," says Lutton. "In other words, are their interests aligned with those of long-term shareholders?" Morningstar also considers each board's workload. "How many funds are they overseeing and is that realistic? A dozen might be too many funds for one board to keep track of."
As for manager incentives, the SEC now requires fund companies to disclose to shareholders their compensation structures, enabling Morningstar to glean this information from public disclosures. "Managers should be paid based upon how funds perform, not based on how many assets they collect," says Lutton. The classic example is a small-cap fund that should remain small to maintain performance, but incents its manager to grow the fund — to the detriment of existing shareholders.
"We also like to see fund managers investing in their funds," adds Lutton — ideally $1 million per investment style. In other words, if a manager is responsible for three different large-cap funds, he would have at least $1 million spread across all three. "Since we've launched this project, managers at some funds — for example, Janus and MFS — have increased their investments to earn their funds better grades. So managers are paying attention to these scores."
In assessing a fund's fee structure, Morningstar's main concern is that investors are charged a fair price to invest in the fund, something they determine by comparing fees among all funds and also studying fee trends for a fund that has grown. "A fund gets credit for lowering its expense ratio as it grows. We like to see the fund pass on economies of scale to shareholders."
The final component of the stewardship rankings — the fund's corporate culture — is perhaps the most subjective to assess, says Lutton, and is based largely on Morningstar analysts' knowledge of the fund and how it treats shareholders. What are its shareholder communications like? Does it do a good job explaining its investments and what's driving performance? And does it admit its mistakes ("We shouldn't have bought XYZ, as it was a drag on performance").
Another aspect of corporate culture is personnel turnover, says Lutton. "Is this a fund at which people like to work or does the fund have trouble keeping managers?"
Shareholder-Friendly Funds
