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How Good Stewardship Predicts Superior Performance

New Morningstar data on fees, manager ownership, and corporate culture make it easy to select good caretakers of capital.

Kailin Liu, 06/08/2012

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.

The firm average fee rankings are informative because most don’t vary much within fund families. The fee level of a firm’s funds cluster around the family average, so there are not too many outliers within a family. Fidelity and American Funds’ fees, for example, were consistently on the lower end. However, there are firms, such as AllianceBernstein, where fund prices were more disparate.

Taking Ownership
Another data point that is predictive of good shareholder outcomes is manager ownership. Our stewardship study found that among core equity and core fixed-income funds, those with manager ownership of more than $1 million had better risk-adjusted returns than funds whose managers invested no money in the fund.

According to the study, core equity funds where the manager held more than $1 million had an average 10-year Morningstar Rating of 3.83 stars, compared with 3.23 stars for core equity funds with no investment. Fixed-income funds with more than $1 million in manager investment had an average 10-year Morningstar Rating of 4.06 stars, compared with 3.48 stars for funds with no investment. Fixed-income funds with higher manager ownership were also less expensive compared with their peers; funds with more than $1 million in manager ownership had below-average fees in aggregate, while on average, bond funds with no ownership had an average fee level.

The positive effects of high manager ownership were so strong that in the new Morningstar Stewardship Grade methodology, we only consider the percentage of assets that a firm has in funds where a manager is in the highest tier of fund ownership—more than $1 million.

It is encouraging that a healthy number of firms have adopted this industry best-practice. Out of the 653 firms that had firmwide manager ownership data available on April 30, 117 firms had more than 80% of assets in funds with manager ownership of more than $1 million. Unfortunately, an overwhelming number of firms still had no ownership in fund shares; 424 firms had no assets in funds with manager ownership in the highest tier.

High manager ownership is important because, like fees, it is predictive of better fund performance and survivorship. As of April 30, firms with 80% or more assets in funds with manager ownership in the highest tier had a five-year success ratio of 53%, compared with 41% for firms with 20% or less assets in funds with the highest tier of ownership. The prominent fund firms with more than 80% of assets in funds with the highest tier of manager ownership tended to be firms with limited lineups, including Dodge & Cox, Fairholme, and Oakmark, although Artisan, American Funds, and Janus make the list as well. These firms all earn full credit in the manager ownership portion of the new stewardship methodology.

Shareholder-First Culture
Corporate culture has the most weight in the stewardship methodology, and it’s also the most qualitative portion of the grade. Morningstar analysts grade the corporate culture of firms based on how they treat their shareholders. Firms that earn good marks treat shareholders like owners by offering easy-to-use, best-in-class funds, hanging on to long-tenured managers, and candidly discuss their successes and failures. Morningstar assigns corporate culture grades to firms after a lengthy research process that usually involves an onsite visit to the fund firm. The analysts’ conclusions are subject to a peer-review process that is designed to ensure that the methodology is applied fairly. As a result, evaluating a firm’s corporate culture is difficult to accomplish using only data.

Nonetheless, one of the most significant attributes that the culture score tries to measure is whether a firm is a stable organization with a tested investment process. Morningstar now calculates a firm’s average manager tenure and a five-year manager- retention rate to help characterize the fund firm. Morningstar calculates firmwide tenure in two ways: a simple average of manager tenure and an asset-weighted manager tenure. Typically, the asset-weighted manager-tenure figure is higher because funds with a track record of success and more-experienced managers tend to gather more assets than funds that have a short track record and inexperienced managers. Both data points can tell investors something about firm culture and subsequent fund performance. However, for this article, we’ll highlight the simple average because it shows how likely investors are to get an experienced manager at the helm of their fund, regardless of which offering or share class they choose.

We found that firms with average manager tenure of 10 years or more had a five-year success ratio of 44% and a five-year risk- adjusted success ratio of 46%, compared with a success ratio of 39% and a risk-adjusted success ratio of 37% for firms with an average manager tenure of five years or less. The difference between the two groups’ five-year star rating was very small, and the low-tenure group actually scored slightly better, possibly because of survivorship bias.

Measuring a firm’s performance relative to its five-year manager retention produced even stronger results. To arrive at a firm’s five-year manager-retention rate, we looked to see which managers were running the firm’s funds on Dec. 31 of a given year, and then we determined who remained one year later. We combined these annual calculations over a five-year period, which helps investors track a firm’s stability over a longer period. Firms with a five-year manager-retention rate of 90% or higher had a five-year success ratio of 47% and a risk-adjusted success ratio of 47%, compared with 37% and 37%, respectively, for firms with a five-year retention rate below 90%. Again, there were not large differences in the average five-year star ratings between the two groups.

Ready, Set, Screen
Paying attention to these stewardship data points will give advisors a strong start on picking good stewards of capital for their clients. If a fund comes from a firm that meets Morningstar’s standards of low expenses, high manager ownership, high manager tenure, and high manager retention, the odds are they will be a good partner to run clients’ assets.

Kailin Liu is a Mutual Fund Analyst with Morningstar.
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