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2012-05-28 06:19:38
September 25 2007 | Filed Under Mutual Funds
In 2004, independent investment research company Morningstar Inc. introduced a
Fiduciary Grade (subsequently renamed as the Stewardship Grade) system to
complement its ratings service of mutual funds by factoring in areas of mutual
fund governance and operations. The stewardship grades have no influence on its
star ratings - they are two separate tools for appraising a mutual fund.
SEE: Morningstar Lights The Way
Investors use Morningstar Rating as a signpost of mutual fund performance in
terms of both return and risk. These ratings are a valuable tool for
objectively comparing the performances of different mutual funds. Read on as we
cover this Morningstar service and what is means for investors.
Background
In 2003, former New York attorney general Elliott Spitzer launched actions
against some mutual fund companies for allowing their privileged clients to
profit from improper activities such as late trading. In its wake, investors
realized they needed more than the past performance-based ratings to assess
mutual funds.
A Morningstar rating does not get at critical intangibles such as how seriously
the mutual fund company takes its fiduciary responsibility to mutual fund
shareholders. Or, how aligned the interests of the mutual fund manager and the
mutual fund company are with those of the fund investor?
To address this need, Morningstar created the Stewardship Grade in 2004 to look
at the regulatory issues, board quality, manager incentives, fees and corporate
culture of mutual funds. The company revised its grading system in September
2007, imposing new, tougher standards.
How the Mutual Funds are Graded
The Morningstar Stewardship Grade is based on the evaluation of five areas
critical for mutual fund governance and operations. Morningstar generally
assigns to mutual funds points ranging from 0 (Very Poor) to 2 (Excellent) in
increments of 0.5 for each of these five areas. There is no general consensus
among investment professionals as to what constitutes a "favorable" rating.
However, logic suggests that funds with an overall rating of A or B would be
preferable to those with lesser grades.
The scores of each of the five areas are aggregated and the mutual fund is
assigned a Stewardship Grade based on the total number of points:
A=9-10
B=7-8.5
C=5-6.5
D=3-4.5
F=2.5 or less
1. Regulatory Issues: Morningstar examines whether the mutual fund company has
had any regulatory issues within the past three years. If so, what corrective
actions has the mutual fund company implemented?
2. Board Quality: Morningstar looks for a demonstrated track record of the
mutual fund board in protecting the interests of mutual fund investors. Mutual
funds get kudos if their independent directors invest in the mutual funds.
3. Manager Incentives: This score is based on Morningstar's evaluation of
mutual fund ownership and compensation structure. Mutual funds in which the
fund's manager owns a meaningful stake in the fund score high on the fund
ownership dimension. A compensation structure that rewards the mutual fund
manager for long-term mutual fund performance is favored.
4. Fees: Mutual funds are rewarded for having expense ratios lower than those
of their peers and for effectively reducing their expense ratios with asset
growth.
5. Corporate Culture: Morningstar looks for tangible evidence that the mutual
fund company takes its fiduciary responsibility seriously. Among the factors it
considers are softer issues like whether the company closes mutual funds when
they get too large and whether the company starts trendy mutual funds to garner
assets.
Using the Morningstar Stewardship Grade
1. Buy and Hold Investors: Buy and hold mutual fund investors first need to
examine how mutual funds in their portfolios stack up on the two measurements -
Morningstar rating and Stewardship Grade.
Mutual funds that rank favorably on both dimensions may be retained and mutual
funds that rank unfavorably on both dimensions may be replaced by ones that
rank favorably.
For mutual funds that rank favorably in one dimension but not in the other, the
answer is not so clear-cut. Retaining a fund with a strong Morningstar rating
but lower Stewardship Grade is a matter of personal choice. Conversely, a
mutual fund's Fiduciary Grade may be satisfactory but the Morningstar rating
may be unfavorable. This may just be a case of the mutual fund manager going
through a temporary bad patch. Investors have to weigh these factors along with
tax consequences before deciding to sell a mutual fund.
Given the number of mutual funds available, investors seeking new mutual funds
to add to their portfolios should, in general, have no trouble in finding
mutual funds with a favorable Morningstar rating as well as a Stewardship
Grade.
2. Tactical Asset Allocators: A tactical asset allocators uses an active
investment strategy and typically invests in mutual funds such as sector funds.
Because tactical asset allocators seek superior performance during their mutual
fund holding period, factors such as superior long-term performance, which
determine a Morningstar rating, are less important to them. However, these
investors typically seek to own mutual funds within a single family for
administrative ease. As such, tactical asset allocators will find the
Stewardship Grade useful in evaluating and choosing mutual fund families to
implement their strategies.
What's it worth?
The Stewardship Grade system is a blend of several metrics. The grading of
mutual funds on regulatory issues is backward-looking and, as such, may not be
a prognosticator of potential future trouble. The grading system includes a
quantitative dimension in mutual fund fees. Also included are qualitative
dimensions such as mutual fund corporate culture, manager incentives and the
quality of the board of directors.
While Morningstar rating does an excellent job of objectively evaluating past
performance, financial markets do not allow the investor to predict future
performance based on these ratings alone. Many times, funds with a rating of
four or five stars do not live up to their expectations.
Conclusion
Investors will find the Stewardship Grade system valuable in their mutual fund
decision-making process, if only as a tool for comparing different mutual
funds. The Stewardship Grade provides mutual fund shareholders with much-needed
insight into the governance and operations of mutual funds. The system is a
good first step and may improve as Morningstar continues to refine the
Stewardship Grade system over time.
by Sam Subramanian
Sam Subramanian, Ph.D., MBA, is managing principal of AlphaProfit Investments,
LLC. He edits the AlphaProfit Sector Investors' Newsletter", a publication that
discusses investments using Fidelity mutual funds. To learn more about
AlphaProfit and to subscribe to the FREE newsletter, visit www.alphaprofit.com