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What Makes a Grade A Fund Company

Two exemplary stewards of shareholder capital.

Laura Lallos, 11/13/2012

Quick: Name as many of the leading U.S. fund companies as you can off the top of your head. Vanguard, Fidelity, American Funds, PIMCO, T. Rowe Price … did Dodge & Cox spring to mind? Perhaps not; Dodge & Cox is not a household name and has never tried to be. But the company is the 13th-largest mutual fund provider in the U.S., with $120 billion in assets as of the end of September.

Self-directed, no-load retail investors--such as the subscribers to our newsletterMorningstar FundInvestor--are in the know. In a recent survey of these informed readers, we found that half of them own at a least one Dodge & Cox fund. Only three fund companies had higher rates of ownership: Vanguard (85%), Fidelity (62%), and T. Rowe Price (60%).

Dodge & Cox deserves the attention: It is one of the finest fund companies there is.FundInvestor's editor Russ Kinnel recently ran a quantitative assessment of the largest fund companies and Dodge & Cox came out on top.

Dodge & Cox also shines in our Stewardship ratings, which incorporate qualitative as well as quantitative components. It has the rare distinction of earning not only an overall A, but an A for the individual components that go into the rating: Corporate Culture, Manager Incentives, Fees, and Board Quality. (For the fifth component, Regulatory History, a company can earn only Neutral or Negative; we don't give As for simply following the rules.)

So what makes for a straight-A fund company? The only other company that rates as highly is Primecap Management, and it has a lot in common with Dodge & Cox.

Corporate Culture
These two shops feature management teams with long tenures who employ fundamental research and take a long-term perspective. That's not to say that a fast-trading quant shop with a star-manager system would be precluded from earning an A. But it is easier to predict continued success for fund companies that minimize key-person risk, nurture and retain talent, and follow a clearly articulated long-term strategy.

Neither company does aggressive marketing, and each stays within its circle of competence. Dodge & Cox opened its first fund in 1931 and has only five offerings today--all of which have earned a Morningstar Analyst Rating of Gold. Primecap was founded in 1983 and opened its three Gold-rated mutual funds in 2004.

Both firms are run by the fund managers themselves. That is no doubt why protecting their successful investment strategies comes first. You won't find them rolling out the fund flavor of the month to take advantage of hot money. What's more, Dodge & Cox closed its popular Stock DODGX and Balanced DODBX funds in 2004 after assets flooded in and did not reopen them until 2008, after considerable outflows during the financial crisis.

Manager Incentives
Morningstar believes that managers who have significant amounts of money invested in their funds have the strongest incentive to do well for shareholders. The SEC requires fund companies to reveal levels of manager ownership in bands ranging from up to $10,000 to $1 million or more. Every Dodge & Cox and Primecap fund benefits from manager investment at the highest level.

Fees
Low costs are an indication that a fund company is putting shareholders first--and funds with low expense ratios have a better chance of long-term outperformance. To determine a fund company's fee grade, Morningstar first ranks each of its funds against its fee level comparison group--similar funds of the same share class. (For example, all large-cap no-load funds are ranked against each other, while large-cap A shares are in a separate group.) We then average fee level percentiles for all the funds in the family.

Here, too, Dodge & Cox and Primecap excel. Both fund companies have just one, low-expense no-load share class for each fund, and both have average fee levels in the cheapest quintile. Dodge & Cox funds' large asset bases allow for economy of scale; they charge rock-bottom expenses for actively managed funds. Primecap's funds aren't quite as cheap, but their expense ratios are still among the lowest and have decreased significantly as fund assets have risen.

Board Quality
The five Dodge & Cox funds share the same board of trustees, comprising three interested and five independent trustees. While we generally like to see more independent boards, this one has a long history of doing right by shareholders. It has ensured low fees and agreed to close the funds when inflows threatened to hamper the investment process. The independent trustees have a diverse range of relevant experience and have significant investments in the funds. The newest members are in their fifties, which will help ensure continuity as older trustees approach the mandatory retirement age of 72.

The Primecap board governing all three funds has also looked after shareholders' interests. It started with three members in 2004 but expanded to five by mid-2008. Four of the trustees, including the chairman, are independent, and they are all invested in the funds. They have steadily lowered the funds' expenses from 1.25% to less than 70 basis points.

Regulatory History
To top it all off, neither fund company has had regulatory infractions.

The Whole Package
When a fund company is this strong, it gives us confidence to stick with its funds during bouts of underperformance. For example, while Dodge & Cox Stock and Balanced funds stumbled badly during the financial crisis, we considered their long-tenured managers and time-tested strategies and gave the funds our highest Analyst Rating.

Some shareholders did not extend the same benefit of the doubt; these funds have seen net outflows since 2007 even as their fortunes have improved. We hope that our evaluations of the companies behind the funds will give investors a broader context in which to assess periods of out- or underperformance and make the right investments for the long term.

Morningstar gives comprehensive Stewardship Grades primarily to the largest fund companies, but also does a thorough Parent rating  
(considering the same factors) for every fund company with at least one fund that has an Analyst Rating. A positive Parent rating indicates that a good fund has a good chance of remaining a winner. Premium subscribers can view these assessments under the Fund Analysis and Stewardship tabs for those funds that we cover.

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