Our new methodology makes it tougher for funds to earn top grade.
Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.
Morningstar relaunched its Stewardship Grades for funds under a revised methodology, which was designed to reward the industry's best stewardship practices. As a result of the changes, it's tough to get a top grade. In fact, we graded more than 1,000 funds under the improved methodology, and just two funds earn perfect scores for stewardship and only 6% get A grades.
Why is it so difficult for funds to earn a top Stewardship Grade? The changes we've made to our methodology are a key part of the answer. To be sure, the five main tenets of the grade haven't changed. We still look at corporate culture, fund board quality, manager incentives, fees, and regulatory history when assessing whether a fund is a good caretaker of capital. But the improvements we made to the methodology are designed to reward funds that consistently put shareholders first, and funds that aren't as shareholder-friendly now receive lower grades.
Spotlighting Corporate Culture
For example, we now attach twice as many points to the corporate-culture portion of the grade. Corporate culture is worth as much as 40% of the total grade, up from 20%, because we think that the underlying culture of a firm gets at the heart of how well a fund company stacks up as a steward of investors' capital.
Firms with the strongest corporate cultures consistently place fund-shareholder interests first. And we've found that a fund firm's corporate culture sets the tone for the other four areas of the grade. We've noticed that funds with fundholder-focused corporate cultures usually have fund-performance-based manager-compensation plans, strong fund-manager investments in the funds, and reasonable expense ratios on the funds. Take T. Rowe Price, for example. Many of its funds earn overall A grades because the firm's corporate culture puts fund shareholders first, its manager-compensation plan hinges on long-term performance, and most of its funds are reasonably priced.
On the flip side, funds supported by weaker corporate cultures--those that put asset-gathering and business interests ahead of caring for current investors--usually show poorly in other areas as well. Federated's funds, for example, earn D grades for corporate culture, and the firm's manager-compensation plan doesn't stress strong long-term performance, its fund managers rarely invest in the funds they manage, and fees on some of the funds are far too high, in our view. The Federated funds' overall Stewardship Grades are mostly D's and F's.
Independent Watchdogs Are Best
Another area where some funds lost credit toward their overall Stewardship Grade is the board-quality section. To receive full credit for board quality, we now require fund boards to be led by independent chairmen and have at least 75% independent directors on the board. We're placing more emphasis on board independence because we think highly independent boards are best able to address the conflicts of interest between the asset-management company and fund shareholders. This conflict is particularly relevant when it comes to negotiating fund fees and approving contracts relating to fund management and administration.
Funds in the Fidelity family, for example, all lost some credit in the board-quality section of the grade because the chairman of its fund board, Ned Johnson, is also an executive and primary owner of the advisor to Fidelity's funds. In the past, the fund family has been slow to close some of its most successful funds, and we wonder whether an independent chairman would have been a stronger advocate for keeping assets in check to protect the funds' existing shareholders. Johnson directly benefits from asset growth because it leads to more revenue at Fidelity. Most Fidelity funds get C's under the new methodology, whereas they previously earned mostly B's.