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July's Mutual Fund Red Flags

These chefs aren't eating their own cooking.

Laura Pavlenko Lutton, 07/17/2007

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.

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Would you dine at a restaurant where the cooks wouldn't eat what came out of the kitchen? We wouldn't either. That's why we're leery of fund managers who don't invest in the funds that they run. We think a significant investment in one's own fund signals conviction in the investment process and better aligns the manager's own financial interests with those of long-term shareholders.

There are many otherwise strong funds whose managers have no investment in them. (One of the funds mentioned below is an Analyst Pick.) But if a manager doesn't invest alongside fundholders, we think that warrants a Red Flag. After all, we think a manager is more likely to think and act like an owner if he or she actually is an owner.

Touchstone Sands Capital Select Growth PTSGX
This large-growth mutual fund is run by three managers from Sands Capital Management-Frank Sands Sr., Frank Sands Jr., and David Levanson-none of whom invested in the fund as of Sept. 30, 2006. It's possible that the managers have a stake in this investment strategy through an institutional version of the product, like a separate account. But we prefer that fund managers invest in the public mutual fund version of their strategy because then they implicitly sign off of the mutual fund's fee structure. Fundowner-managers also are subject to the same taxable events as other fund shareholders, such as distributions, and therefore may be more likely to trade with taxes in mind.

Vanguard Extended Market Index VEXMX
When it comes to core funds, we think it's a best practice for fund managers to make sizable commitments to their mutual funds. For the purposes of Morningstar's Stewardship Grades for mutual funds, we think a sizable investment is $1 million or more. Vanguard Extended Market Index manager Donald Butler didn't own any shares of his fund as of Dec. 31, 2006, the latest data available.

We find Butler's lack of ownership puzzling because this is a wide-ranging mutual fund that tracks a group of stocks outside the S&P 500 Index that clear some financial-health hurdles. This fund would provide sensible exposure to smaller-cap stocks, and Butler has had plenty of time to buy it-he's coming up
on his 10-year anniversary at the mutual fund. Butler also notably doesn't invest in his other charges, Vanguard Institutional Index VINIX, an enhanced S&P 500 Index fund, and Vanguard Mid Cap Index VIMSX, an Analyst Pick in the mid-blend category.
 
Overall, fund-manager ownership among Vanguard's index funds is pretty spotty. Perhaps the managers feel that passive indexing depends more on the computer models used to replicate the bogy than on their singular role in the investment process. But we still think it's important for the managers to endorse the fund's investment process by buying at least a token stake in the mutual fund.
 
USAA International USIFX
If you own a subadvised fund, particularly one run in a similar manner to a fund run by the manager's primary employer, the chances are good that the fund manager doesn't own shares.

Take Analyst Pick USAA International, for example. Lead manager David Mannheim doesn't own the mutual fund, but he has invested more than $1 million in the MFS fund whose foreign sleeve he runs in an almostidentical style, MFS Global Equity MWEFX. Given Mannheim's 15-year tenure on the MFS mutual fund, it's not surprising that he has built up a substantial position in that world-stock fund. Even so, if he owned the USAA version of his fund, he'd be saving 0.25% per year in expenses over MFS Global Equity's front-load A shares.

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