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Morningstar Stewardship Grades: Three Lessons Learned

We've learned a few things about mutual fund governance.

Laura Pavlenko Lutton, 05/15/2007

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. Fund Analyst Picks are available on Premium Morningstar.com.

Morningstar's Stewardship Grades for funds are nearing their third birthday, and since the grades' inception, we've learned a lot about how to evaluate funds' care for shareholders' capital. We launched the grades in August 2004 to help investors make better investment decisions in the wake of the mutual fund industry's market-timing scandal. We wanted to shine a direct light on funds that employ the industry's best stewardship practices and consistently act with shareholders' best interests in mind. Equally important, given the potentially severe consequences of weak stewardship, the grades also point to funds that fall short.

We consider five areas when determining a fund's grade: corporate culture, board quality, manager incentives, fees, and regulatory issues. In addition to relying on our analysts' knowledge of various fund companies based on years of experience with the people and practices of the firm, we use scores of data, SEC filings, interviews with management and fund boards, and fund-company visits to evaluate each of the five areas and arrive at an overall grade.

In grading about 1,200 funds over the course of three years, we've noticed some interesting trends. The industry's governance practices have evolved significantly in the past three years, so we plan to refine our Stewardship Grade methodology to continue to reward best practices and to further recognize those firms that go above and beyond the industry standard. For example, we'd like to better recognize fund boards that have elected independent chairmen in recent years. Ultimately, as before, we want to do our best to identify the industry's top stewards and to continue to identify the laggards. We're putting the finishing touches on the refined methodology now, and we'll share the changes with you in mid-June. In the meantime, here are some key conclusions we've drawn from the grades:

Lesson One: Disclosure Is the Shareholders' Friend
When we started this initiative, much of the information we now use to assess manager incentives was not publicly available, making it difficult to assess which managers were best aligned with shareholders. Only in February 2005 did the Securities and Exchange Commission start requiring funds to disclose the factors that dictate a fund manager's pay and how much money (within some set ranges) the fund manager has invested in the fund he or she runs.

As you might imagine, this disclosure has been enlightening. Some fund shops pay their management teams primarily for their ability to deliver strong relative and absolute returns to shareholders--a best practice, in our view. But others disappointingly pay based on asset or profit growth, both of which may not be in fund shareholders' best interests because bloated funds sometimes underperform.

We like the way the Davis and Selected American funds describe their manager compensation plan in the funds' Statement of Additional Information. There, fund managers' bonus payments vest after a specified period (usually five years), but the managers' bonuses can be reduced should the funds lag their peers during the period.

Meanwhile, disclosures describing pay plans at other shops have left a lot to be desired. Fidelity, along with many of its peer firms, leaves out some key details of its compensation plan, making it tough to determine whether fund managers' own financial interests are aligned with shareholders'. These firms comply with the letter of the disclosure law, but not with its spirit.

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