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Good Funds With Bad Pedigrees

Sometimes even bad parents can produce worthwhile offspring.

Laura Lallos, 10/02/2012

We recently delved into the attributes of fund companies that earn either the best or worst Parent ratings. Morningstar's director of active fund research, Michael Herbst, counted himself among those investors who won't consider an offering from a Negative-rated parent, regardless of the fund's particular qualities.

That's understandable. If a fund is backed by a company that does not control costs or cannot retain top management, that fund may inevitably lose its edge, no matter how good it is today. As we demonstrated in a follow-up column, the factors that lead to a Positive Parent rating are also linked to superior fund performance.

So why ever choose a fund with a bad pedigree? A Negative Parent rating can be driven by factors that may not affect certain funds in a company's lineup. Sometimes specific positives can outweigh the negative in the background.

Take Charles Schwab's index offerings. Schwab SCHW recently announcedexpense reductions that make its ETF index funds the cheapest around. The Schwab U.S. Broad Market ETF SCHB now charges a rock-bottom 0.04%, edging past the 0.05% fee for Vanguard Total Stock Market VTI. Investors can open a brokerage account with Schwab for only $1,000 and trade the firm's ETFs commission-free. That provides a low-entry, cost-effective way to dollar-cost-average into the broad market.

You may well be wary. After all, Schwab Total Bond Market SWLBX lagged its benchmark miserably during the financial crisis because it was overloaded with mortgage-backed securities. And if you are investing large amounts of money, Vanguard's higher trading volume could translate into lower trading costs. But Schwab has a good track record with its stock index funds, and you might prefer this fund's benchmark, the Dow Jones U.S. Broad Stock Market Index. (Vanguard announced today that its Total Stock Market Index fund and ETF shares will transition from tracking the MSCI U.S. Broad Market Index to the CRSP U.S. Total Market Index.)

Schwab's Parent rating partly stems from an SEC complaint detailing misleading statements made about the ill-fated Schwab YieldPlus, a so-called money market alternative that suffered steep losses in the financial crisis. Now headed by Marie Chandoha, Schwab's investment management operation seems to be on a straight-and-narrow path, but we are still reserving judgment. Further, Schwab funds have minimal management ownership, and that is a significant component of the Parent pillar because managers with money on the line have an incentive to excel.

Management investment is arguably less critical for index funds, though. Price, on the other hand, is key, and by that measure, Schwab fares well. Indeed, Schwab Total Stock Market Index SWTSX has earned an Analyst Rating of Silver. With a 9-basis-point expense ratio and an entry-level $100 minimum investment, it is a compelling option for new investors buying their first mutual fund. Of course, shareholders burned when Fidelity jacked up expenses on some of its retail index fund shares last year might be skeptical, but Schwab's determination to compete on cost has become a defining aspect of its culture.

Actively managed funds can also rise above bad parents, particularly when they are run by subadvisors. We called Laudus Growth Investors U.S. Large Cap Growth LGILX "a hidden gem" when we issued it a Bronze Analyst Rating earlier this year. The fund earns Positive scores on four of the five pillars that go into the rating--the only Negative being its parent, Schwab. Lawrence Kemp and his team of experienced analysts work for subadvisor UBS UBS, and they have created a terrific 10-year track record using a disciplined focused-growth strategy. Given that and relatively low expenses, the fund has a good chance of maintaining its edge.

Laura Lallos is a former Morningstar analyst and editor, and a frequent contributor to Morningstar Advisor magazine.
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