New Morningstar data on fees, manager ownership, and corporate culture make it easy to select good caretakers of capital.
This article originally appeared in the June/July 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Advisors put their practices in the hands of the fund firms in which they invest, so it’s important to determine which firms will treat clients’ capital with care. To aid in such stewardship research, Morningstar created a suite of new data points that make it easy to measure fund firms on a few key factors.
The new data related to fees, fund managers’ investments in their funds, and fund managers’ tenure may also point advisors to strong long-term performers. A Morningstar study in 2011 of its Stewardship Grades for mutual funds showed that good stewards delivered better results, in the forms of better fund performance and higher rates of survivorship, relative to mediocre or poor stewards. The new data reinforce those findings and can help point investors toward shareholder-friendly firms.
In this article, we compare some of the new data and funds’ performance. To measure performance, we looked to two other new metrics, the Morningstar 5-Year Firm Success Ratio and the Morningstar 5-Year Firm Risk-Adjusted Success Ratio. Both of these measures neutralize survivorship bias by designating funds unsuccessful if they existed at the beginning of the five-year period, but were liquidated or merged away before the five-year period was up. The 5-Year Firm Success Ratio measures the percentage of a firm’s funds that survive the five-year period and also outperform 50% of its category peers for that period. Likewise, the 5-Year Firm Risk-Adjusted Success Ratio measures the performance of funds that survive the period and outperform on a risk-adjusted basis.
Fees That Please
Fund fees are an elegant test of good stewardship because there’s nothing more quantitative than fees—and no data point is stronger at predicting superior long-term returns. That’s because fees drag on funds’ returns every day, making it increasingly difficult for the investments to outperform over the long term. Morningstar’s research has shown that the lower the funds’ fees, the more likely they are to produce peer-beating long-term returns, better risk-adjusted returns, and higher chances of survivorship.
Morningstar puts fees in context through the Morningstar Fee Level Percentile Rank, which compares fund share classes’ expense ratios by strategy type and sales channel and then ranks the results. These individual fund rankings are helpful when comparing individual funds, but by aggregating them to the firm level, investors can tell at a glance whether a fund family’s offerings are cheap or expensive--and therefore, likely to outperform or not. The Morningstar Firm Average Fee Level Percentile Rank is the simple average of the Fee Level Percentile Rank for all fund share classes of a fund firm. Not surprisingly, there is a strong correlation between a firm’s average fee percentile rank and the success of its funds. As of April 30, firms with average fee level rankings in the cheapest third had an average overall Morningstar Rating of 3.08 stars and an average five-year success ratio of 50%. Firms with average fee level rankings in the most expensive third averaged 2.89 stars and had a five-year success ratio of 40%. In other words, about half of the funds from cheaper firms both survived and outperformed in the five-year period, compared with 40% of funds from firms in the most expensive third.
Vanguard, the mutually owned industry cost leader, had an average firmwide fee percentile rank of just 3, and its funds on average outperformed their category peers with 3.54 stars each. Nearly three fourths of its funds had been successful, whether judging by category percentile rank or by star rating. Low fees aren’t a guarantee of outperformance, however, as shown by Dodge & Cox. Though the small-value-oriented shop had a firm average fee percentile level of 13, its funds underperformed on average over the five-year period, primarily because their value strategies struggled mightily in 2008’s market crash.
Similarly, there are firms with expensive funds that overcame their high expense ratios over the five-year period. Waddell & Reed (average fee percentile rank of 71) had strong perfor- mance and success ratios. But more typical were results like Calvert’s, where performance and the success ratios did not measure up.