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The Proof Is in the Pudding

Why the ingredients of good Parents make for better investments.

Kailin Liu, 09/25/2012

Last week we wrote about the Parent pillar of the Morningstar Analyst Rating. As we pointed out, the fund companies that receive Positive Parent scores have a few traits in common. Those firms' funds frequently feature lower fees, longer-tenured managers, and managers who invest their own money alongside fund shareholders. However, we don't expect investors to simply take our word for it that these practices are important. Instead, in this article we offer data and studies to demonstrate that Parent ratings, and the metrics we use to assign them, have very real implications for investor experience.

The Price Is Right
One of the most straightforward measurements of shareholder-friendliness is mutual fund expenses. Lower fees generally increase investors' chances of success, and firms will often take steps to reduce expenses, such as instituting fee breakpoints or lowering overall expenses as a fund grows. Of all the firms that currently receive Parent ratings from Morningstar, those with a Positive rating have a Firm Average Fee Level of 49, suggesting that their funds are generally in line with their peer groups. Firms that receive Neutral or Negative ratings weigh in at Firm Average Fee Levels of 53 and 65, respectively, suggesting a slightly more expensive menu of investment options.

- source: Morningstar Direct as of 8/31/2012

Some firms argue that higher expenses are justified because the managers add enough value to make up the cost. Unfortunately, the data suggests otherwise. My colleague Russ Kinnel conducted a study in 2011 that showed that lower-cost funds consistently outlive and outperform higher-cost funds. For some asset classes the difference is eye-opening. According to his study, cheap municipal-bond funds survived and outperformed more than 6 times as frequently as the most expensive municipal-bond funds.

His conclusions hold true at the firm level as well. When looking at all U.S. open-end mutual fund companies with assets greater than $1 billion, the firms with an average Fee Level of Low or Below Average (that is, 1st to 40th percentile) had, on average, 54% of their funds both survive and outperform their category average in the five-year period. In contrast, firms with an average Fee Level of Above Average or High (that is, 61st to 100th percentile) could only say the same for 42% of their funds.

- source: Morningstar Direct as of 8/31/2012

Kailin Liu is a Mutual Fund Analyst with Morningstar.

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