Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
Morningstar's fund analyst team has been evaluating funds' shareholder friendliness since 2004. Here to discuss that research with me is Laura Lutton. She is editorial director for Morningstar.
Laura, thanks so much for being here.
Laura Lutton: Thanks for having me.
Benz: So, Laura, let's quickly run through what you look for when you evaluate a fund Stewardship?
Lutton: Okay. We look at five different things and really what we're after is, how well do we think this fund is going to care for shareholders' capital going forward in the future. So, we look at things like corporate culture of the fund family. How fundholder focused is the firm? Are they more likely to put their fund shareholders' interests before their own profits. That type of thing.
Benz: So, what's an example of putting their interest before profits? How do you know?
Lutton: A good example would be closing a fund that they think is getting to be too large. It's easy for fund companies to leave funds open because flows keep coming in. They make money of those investments.
Funds that resist the temptation to launch trendy funds that they know are going to sell well because people have been interested in commodities funds or …
Lutton: Exactly. So, we look at the launch and merger record. We look at, does firm close funds? We look at how they market their funds. Are they fairly team in how they talk about returns? Or is that type of information up in lights?
Benz: Okay. So, corporate culture is a biggie in the methodology.
Benz: You also look at fees.
Lutton: We look at fees. We look at the fund board that oversees the fund to see if they have acted in shareholders' best interest by negotiating lower fees. The fund board gets to vote to close funds. They have got a say in that decision. Then, we also look at the fund managers' incentives to see if their own economic interests are aligned with shareholders'.
Specifically, we look at how the fund managers get paid. Most of their pay comes through their annual bonus, and funds have to tell us, through their statement of additional information, what the criteria are that determine what the fund manager's bonus is going to be. Specifically, we're looking to see whether long-term performance, good long-term returns, are driving the bulk of the manager's pay, because we think that's going to have the manager act in a way that's going to benefit fund shareholders.
Benz: Right. And you also look at whether the managers own their funds?Read Full Transcript
Lutton: Absolutely. We think skin in the game is critical. And we like to see a lot of money in funds because we think that way the fund manager is sharing the shareholder's experience. They're paying the same fees that the fundholder is. They are subject to the same kind of taxable events, whether it's a distribution or what have you. So, we think that's critically important.
Benz: So, those are the key prongs of the Stewardship Grade.
You recently ran some research that looked at the predictive ability of these grades, since we originally launched them, and then we did a revamp of them in 2007. How have they done at predicting performance from those funds?
Lutton: Well, we looked at performance in a couple of ways. We looked at what the star rating was of the fund in the years after we graded it, and funds that had a star rating of 3 stars or higher, we considered successful, and then the funds that had a star rating that was lower than 3 stars or didn't survive, which was a huge issue--a lot of the funds that we graded that got poor Stewardship Grades simply didn't make it to today.
Benz: So, they got merged away or liquidated or something...
Lutton: Merged away, exactly. So, we came up using the star rating test with a success ratio, because we figured if you owned a fund that had 3 stars, 4 stars, 5 stars years later you'd be relatively happy with that.
Benz: So, the 3-5 stars just being sort of a gauge of risk-adjusted return.
Lutton: Right and overall success.
Lutton: We also looked at returns relative to the category rank, and then we also looked at investor returns, which are cash-weighted returns that try to capture whether or not a shareholder actually experienced the total return of the fund, because oftentimes we see that investors buy at the wrong time, meaning after the fund has already gone up, and then they sell kind of in the darkest hour.
We've had some great results. The funds that got A's overall were successful, north of 80% of those funds had a 3-, 4-, 5-star rating three years later.
Benz: ... And had survived.
Lutton: And had survived. Very competitive peer-beating returns overall relative to their category, and there were a couple of areas of the methodology that were particularly strong in terms of predictive ability.
Benz: That's what I want to talk about, which of those did you find to be especially predictive?
Lutton: So, the corporate culture, where we are very qualitatively gauging whether or not we think a fund firm is shareholder-focused, that was fairly predictive.
Perhaps the strongest results we got were for those manager incentives: Is the manager getting paid to deliver strong long-term returns, and then is he or she benefiting from that through ownership of fund shares. And we found that to be quite predictive.
Benz: So, people should really look at those factors: manager ownership and also manager comp?
Lutton: Absolutely. It was the combination of those two factors actually that ended up being pretty predictive.
Benz: Okay. Not in isolation necessarily, but…
Lutton: In isolation as well, too, when we put them together that's where we really saw nice results.
Benz: How about the criteria that were less predictive?
Lutton: So, the least predictive criteria was the fund board piece, and I think there are some selection bias reasons for that. We thought that fund boards that were led by independent chairman and a super-majority of independent trustees would have good results for shareholders, but there are a couple of big fund families that received Stewardship Grades from us that don't have independent chairman and actually have done quite well for shareholders, and that would be Fidelity and Vanguard, specifically. That's about a quarter of our Stewardship Grade coverage. We issue the grades to about a 1,000 funds, and about a quarter of those are Fidelity and Vanguard funds that our analysts actively follow.
Benz: So, they kind of skewed the results you think?
Lutton: We think so, yeah. But, at the end of the day, it's hard for me as an analyst to know to what extent a fund board is pushing back on company management.
Benz: We're not there in those meetings.
Lutton: We're not there in the meetings. We don't know if the fund board said, Fund company A proposed this mutual fund that they just thought was a bad idea, and they said "no way; we're not signing off on that."
That type of event is often not made public, and so it's hard for us to gauge. But there are some things we can look at, like fees and whether the funds close, and whether the lineup looks sensible. But I think all of that stuff that's going on behind closed doors where the fund board really gets to speak candidly with the funds advisors, we're not subject to those conversations.
Benz: So, Laura lastly, I was wondering if you could run through a couple of funds and fund shops that get top marks from the standpoint of Stewardship, and maybe highlight some of the things that you think make them especially shareholder-friendly?
Lutton: So, there are a couple of shops that get great grades from us that are smaller, and I think really know what they're good at and stick with that, and those would be Davis Funds, and then the Dodge & Cox Funds also get very high grades from us.
One of the things that we look at as a sign of good stewardship is the fund family knows its investment process and it sticks with that through and through, and over the long term, we see really nice results for shareholders. So, those will be two examples.
The Vanguard Funds score well on stewardship. They get a great boost from the low fees there, and there I think a firm that also has a fairly sensible lineup. It does a good job, I think, in funds that are hot from a market perspective of holding the shareholder's hand and saying, "even though energy has been the place in the market, don't expect this fund to keep performing like this."
Benz: Closing proactively sometimes as well?
Lutton: Absolutely, absolutely.
Benz: So, that's an example, one of the big shops.
Laura, thank so much for sharing your research.
Lutton: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.