Good parents often raise good children.
If you're born a Roosevelt, Kennedy, or Windsor, you arguably have a leg up when it comes to wealth and fame--even a quirky royal mystique. In the investment world, fund family lineage also can have advantages. Funds offered by Dodge & Cox, Vanguard, or Davis Advisors all are backed by a fundholder-friendly parent company that supports a proven investment process. Similarly, funds offered by firms that have not consistently served fundholders well often operate under a cloud.
Morningstar's research has shown that firms with strong stewardship practices offer funds that are more likely to survive and deliver good results for fundholders. This research also supports Morningstar's inclusion of Parent as one of the five areas that Morningstar studies to arrive at the forward-looking Morningstar Analyst Ratings for individual mutual funds.
Sizing Up Stewardship
Morningstar has been studying funds' stewardship practices informally for decades, and seven years ago, we formalized this research through the Morningstar Stewardship Grades for mutual funds. The grades have evaluated funds' stewardship practices across five areas: corporate culture, fund managers' incentives, fees, fund board quality, and regulatory history.
Morningstar studied the Stewardship Grade methodology earlier this year and found that the grades issued in 2004 and 2007 predicted good outcomes for fundholders in the years that followed. Specifically, funds with high overall grades, as well as funds with top grades for corporate culture and fund managers' incentives, were more likely to survive in the coming years and deliver performance that was at or above the peer-group norm on a risk-adjusted basis. On the flip side, funds earning D and F grades for Stewardship were unlikely to survive: About a fourth of the D funds and a third of the F funds did not survive until the 2011 study.
Morningstar has demonstrated that its Stewardship Grade methodology has helped fundholders identify good investments, so it makes sense to include this methodology as one of the five pillars of the Morningstar Analyst Rating. The Analyst Rating's other pillars are People, Process, Performance, and Price. After qualitatively examining all of these pillars, Morningstar issues an Analyst Rating of Gold, Silver, Bronze, Neutral, or Negative. Morningstar expects that funds earning Gold, Silver, or Bronze medals will outperform their peers on a risk-adjusted basis over a full market cycle. Neutral funds are not seriously flawed but aren't expected to meaningfully outperform. Morningstar does not recommend Negative funds because we don't expect them to keep up with their peers.
Morningstar is making some changes to its Stewardship Grade methodology so that it can better inform the Parent pillar of the Analyst Rating. For example, instead of issuing grades to individual funds, as we have in the past, new grades will be assigned to the funds' parent company. We're also increasing the weight of the Stewardship Grade components that proved most predictive in the March 2011 study. The corporate-culture and manager-incentives components both carry a heavier weight in the new Stewardship Grade for fund firms than they did for fund-level grades. Finally, we're looking firmwide at some former fund-level criteria, including the relative cost of share classes across the fund family and the managers' investments in their funds.
Parent companies of the funds receiving Analyst Ratings will be evaluated through the Stewardship Grade framework. Funds earning Positive ratings for Parent would earn an A or B for their Stewardship Grade. They have demonstrated that their corporate cultures are fund-investor-focused, their boards have served fundholders well, and their fees are reasonable. Fund firms where more than 80% of assets are run by managers with more than $1 million invested in fund shares earn top marks for the manager-incentives portion of the grade. Top stewards also have had clean regulatory records in recent years.
Capital Research and Management Company, the firm behind the American Funds, strikes an impressive stewardship profile and has been rated Positive for Parent. Its corporate culture supports a well-established investment process that has served investors well for decades. Its fund lineup is sensible and plays to the strengths of the firm's investment process. American Funds' managers usually spend their entire careers at the firm. In fact, more than 90% of the firm's assets are run by teams that have at least one manager with more than 15 years of tenure. Expense ratios on its funds almost always land in their Morningstar Fee Level peer group's cheapest quintile. The American Funds have a good regulatory record, and its fund boards meet most of Morningstar's criteria for strong shareholder service.
Several large, diversified fund companies earn Neutral ratings, including BlackRock, DWS, Fidelity, John Hancock, Legg Mason, and Oppenheimer. While these firms each offer some successful funds, their stewardship track record is mixed. Their corporate cultures are not as investor-focused as some industry-leading firms, and their managers' investments in fund shares aren't as large. Fees, which are negotiated by the funds' boards of directors, are not consistently low across the funds' share classes. These weaknesses are not serious enough to swing the firms' Parent ratings to Negative, but their stewardship profiles also are not strong enough to earn Positive ratings.
Relatively few firms have received Negative ratings for Parent (or Negative ratings overall). That's primarily because Morningstar's analysts spend less time covering truly awful funds offered by bad parent companies than they do covering big, successful investments and smaller hidden gems. Among the parent companies rated Negative, however, is Morgan Stanley. The firm's mutual fund business has been in transition in recent years, which has led to new executive leadership and some key fund managers' departures. High fees on more than a fourth of the firm's fund share classes also ding its stewardship marks.
Putting Parent in Perspective
Each of Morningstar's pillar ratings--Parent included--are designed to evaluate an important aspect of a fund that will influence its success over the long term. To be sure, parent companies rated Negative will offer successful funds, and parents rated Positive will produce some duds. But a firm's stewardship practices can have a big impact on fund investors' experiences. In an industry with thousands of choices, it pays to partner with a strong parent.
You can incorporate some Parent research into your own selection process. In Morningstar.com's Premium Fund Screener tool, you can screen on Stewardship Grades alongside other factors such as expenses and Morningstar Analyst Ratings. Morningstar's other software allows users to screen on the Parent pillar rating and the other four pillar ratings, as well as the overall Morningstar Analyst Rating.