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A Stewardship To-Do List for Two Fund Shops

JP Morgan and Pioneer have work to do.

Karen Dolan, 12/04/2006

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.

The Securities and Exchange Commission has been busy this fall, looking into fund company relationships with third-party providers of back-office support. After we learned of the investigation last month, we initiated new Stewardship Grade coverage on JP Morgan funds and updated our grades for Pioneer offerings. (Note, neither JP Morgan nor Pioneer are under scrutiny.)

Former Bank One Funds (which have since been folded into JP Morgan) and AmSouth Funds (whose assets have since been purchased by Pioneer) are under investigation because they did business with Bisys Group BSG, a back-office services provider that has settled wrongdoing charges with the SEC. In a nutshell, the allegations suggest that Bisys charged fund shareholders higher prices for its services than competing providers, and then kicked back some of that money to the fund company.

While the kickback allegations against Bisys are disconcerting, the investigations are related to a fund shop that JP Morgan purchased and assets that Pioneer acquired after the period in question. Yet, what we found during our general review of those firms' stewardship led to concerns about JP Morgan's and Pioneer's current care of investors' capital.

Worrisome Findings
In JP Morgan's case, our research turned up some troubling issues related to the funds' board of directors. Specifically, the current chairman of the JP Morgan fund board, Fergus Reid, also serves on the board for Morgan Stanley funds. There's nothing wrong with that in and of itself, but across the two firms, Reid is responsible for overseeing more than 300 funds. We have a hard time understanding how he can give each of those offerings the degree of oversight required to ensure that shareholders' interests are protected. To be sure, we're pleased that Reid is an independent chairman. Also, he did not serve on the board of the former One Group Funds and thus is not connected to the current investigation. Still, his sizable workload leads us to wonder whether he's spread too thinly to look out for shareholders at each offering he oversees.

In addition to concerns about Reid's oversight, we're also bothered by a recent fine levied against JP Morgan's brokers for improper sales of 529 college savings plans. While the brokers have no direct ties to JP Morgan's asset-management business, which runs its mutual funds, we're concerned that overall, the firm isn't focused on strict regulatory compliance.

As for the Pioneer, we updated our Stewardship Grades for that firm's offerings after AmSouth's name came up in connection with the kickback scandal. Though Pioneer is strong in some areas and the kickback scandal is related to relationships at the AmSouth funds before Pioneer acquired them, we've identified some red flags in its corporate culture. Namely, we're skeptical of Pioneer's handling of mergers, and we're troubled by its manager turnover. For example, Pioneer Small Company was merged into Pioneer Small Cap Value PIMCX and underwent two strategy changes and three management shifts in the process.

What's more, we're also concerned about Pioneer's approach to risk control in its portfolios. We think the firm's efforts may push fund managers to be too benchmark-conscious, which can can lead to mediocrity and may help explain why many Pioneer funds have indeed failed to distinguish themselves over their peers.

We're also disappointed that Pioneer's board has agreed to hike fees at some of its offerings. For example, the expense ratio at Pioneer Small and Mid Cap Growth PAPPX is expected to rise to 1.45% from 1.25% on Jan. 1. To be sure, assets at the offering have been declining, but the new expense ratio is above the median for front-load mid-cap funds. This increase in fees will take a considerable bite out of the remaining shareholders' returns.PAGEBREAK

A Move Toward Best Practices Is Warranted
As noted earlier, the kickback scandal doesn't relate directly to JP Morgan and Pioneer but instead to fund assets that each company now has under its watch. Nonetheless, we do think that both JP Morgan and Pioneer have work to do to become better stewards of investors' capital. To start, both firms should take a close look at industry best practices and try to move all facets of their business more in that direction. For example, the JP Morgan board should question whether chairman Reid is able to devote the time and attention required of a board chairman considering his large workload. Shareholders may be better served if Reid were to step down from the Morgan Stanley board or hand off the chairman role at JP Morgan funds. What's more, we think fund shareholders would be better served if JP Morgan took more of a zero-tolerance approach to regulatory issues, both in its fund business and its distribution arm.

In Pioneer's case, fund shareholders would be better served should the board commit to keeping fees below the median and work toward reaching the cheapest quartile. Given Pioneer's strategy of acquiring firms to help grow its assets, we think the board has sturdy ground to stand on to push for lower fees.

Using Stewardship to Spot Holes
Good stewardship--loosely defined as the propensity of a fund company and fund board to put shareholders' interests first--can't be gleaned by looking at one simple factor. That's why our Stewardship Grades for mutual funds focus on five key components: corporate culture, board quality, manager incentives, fees, and regulatory issues. By looking for strength and consistency in all of those areas, investors can separate the very best stewards of investor capital from the worst. What's more, we have found that weaknesses in certain areas often signal potential holes in others.

Overall, we tend to be skeptical of firms that are below-average or simply average stewards. When considering funds for our Fund Analyst Picks list, for example, we require that they earn Stewardship Grades of B or better. Though we didn't launch our official Stewardship Grades until after the market-timing scandal hit the newswires in 2003, we were already wary of the stewardship practices of many of the firms implicated. In most cases, they tended to offer expensive and trendy funds and sales efforts tended to steer everything else. We think that such behaviors serve as powerful signs that investors aren't the first priority. By looking at stewardship from a number of angles, we aim to give investors the tools needed to find funds that put them first.

Karen Dolan is an analyst with Morningstar.

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