Sometimes even bad parents can produce worthwhile offspring.
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
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
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
It is more difficult to overlook a Negative Parent rating, however, when an active fund manager is directly associated with a troubled parent. Marsico Capital Management, for example, may have addressed its debt troubles, but it is still hampered by extensive analyst turnover and several fund manager departures in recent years. Even safely entrenched managers can be a risky choice if they are not backed up by a solid organization: Permanent Portfolio
If you are considering a fund from a company with a Negative Parent rating, you need to assess whether that rating stems from problems that are likely to drag your investment down. It might be easier to take a pass; as a rule of thumb, a Negative Parent rating is a danger sign. But there are exceptions, as the Analyst Ratings mentioned above indicate. If you are constrained by investment minimums or platforms, or simply intrigued by a successful active strategy, it could be worth your while to dig deeper.