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Grading the Fund Investor Experience

Jason Stipp
John Rekenthaler

Jason Stipp: I'm Jason Stipp for Morningstar.

We just released our biennial Global Fund Investor Experience Report, which measures the experience of fund investors in 24 countries across the globe.

Here to offer some key takeaways from that study is our director of research John Rekenthaler. John, thanks for joining me.

John Rekenthaler: Sure, Jason.

Stipp: So this study is about the experience of mutual fund investors. It's not really about the mutual fund industry. So what does that distinction mean with respect to what you asked in the study and what the goal of the study was?

Rekenthaler: It is quite different. If we wanted to study the fund industry, for example, we would include Luxembourg, which is a massive market. The Luxembourg-based funds are the funds that are available for sale throughout Europe and much of Asia. We don't have Luxembourg [in this study] because this is about fund investors. There aren't many fund investors in Luxembourg.

Similarly, [if we were studying the fund industry,] we would have Cayman Islands or Ireland, other places that are offshore residency. So we are not scoring the fund industry. This isn't a consultant's report for the fund industry to look at and figure out what it should be doing better. It's about the investor experience.

So we're looking at which people are buying funds, and that means not only that you choose different countries, as I said--you choose countries like China and India and U.S. that have large markets and many investors, rather than Luxembourg--but you look at different factors. We are not looking just at what the fund industry does that affects investors, but there are other things, as well. There are the government tax practices, the regulatory environment, even things such as sales and media. So, we even score how the media--how newspapers, the Internet, and so forth--in that country report on funds. … There are certain things that they can be doing to encourage long-term investing and encourage lower-cost investing. And in some countries they do that and they help people. Other countries less so.

So, we are looking across the board at the investor experience. It's not a fund industry scorecard. It's an investor experience scorecard.

Stipp: Wrapping up those findings, what's the objective of the study? What do you hope that the study will bring to light or what kind of change are you hoping that this study might bring about?

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Rekenthaler: We are hoping to bring to light best practices and get a discussion of best practices across the globe, again on all these aspects, and we've had this in the past. This is the third version of the study. Two years ago we had the second version, in 2011. 2010 was the first version. We realized it's a lot of work. We don't need to do it every year. We do it every two years now.

And we've had fund industries in different countries respond to this and look at this and ask questions and probe and think about what they're going. We've had a number of regulatory bodies and regulatory agencies do this. I don't think the press specifically has come to us and said, "How can we get better?" But they see how they're scored on this, and they see the factors that we are looking at. And in sales practices as well, where we look distribution systems and how funds are distributed and sold.

So in all those areas we have had what we hope to get, which is people looking at what we are doing. We are just trying to … get some attention put onto these factors, which otherwise cannot be talked about.

… This is still, to my knowledge, the only study that looks at fund investor experiences except for a couple of cost studies that the academic community has done. There was a lot done on stocks, for stock investors: So, what countries give good disclosure, what countries have good corporate governance. But not for funds. So, that's what we are trying to do.

Stipp: And you looked at four specific areas in this study and in past studies. What are the primary factors that you're grading the countries on?

Rekenthaler: We are looking at fees and expenses, clearly that's critical. Just ask Jack Bogle about that. So, we're looking at the costs of owning funds, which vary between countries.

We're looking at disclosure. So what's the sort of information that you as an investor get, and different countries have different rules and different practices for disclosure. We are actually not looking only at formal rules. If there is not a formal rule set up in a country, and it's not mandated, but funds tend to offer it anyway, we look at what happens in practice. So that's a minor distinction.

So fees, disclosure, regulatory and tax practices, basically government practices.

And finally, as I mentioned before, sales and media, so how are they sold and how are the funds talked about--four areas.

Stipp: And you are grading countries on an A to F scale. How exactly does it work? Is it some kind of a curve or is it each country on its own? What are the criteria behind the grade?

Rekenthaler: That is a question we can talk for a long time [about]. There are many questions in each of these areas. Each question is weighted differently. So some are five-point questions, some are yes or no, like one- or two-point questions. So we sum them all up. Each of the areas gets a score from A to F, depending upon how they do. The scale is set up effectively as kind of a curve. We are looking for a reasonable distribution of grades. We don't want everybody to end up at C+, or we don't want everybody to be A's or F's. So, we're scaling within each of the four areas then we combine the four together. I don't think this time we did scale it, previously we did, but there are some details as to how the grades are put together. But you can rest assured that the countries that are getting B's overall have more overall points than the ones that are getting C's and the one that got a D.

Stipp: And the four areas that you mentioned, … those grades roll up into a primary grade, and when you look at the overall grades for the countries, there were a decent number of B's and C's across the globe, so not a terrible state for investors at all.

But when you look at the high level, what are some of the biggest bright spots that you see where the investor experience is really good, and where are some of the areas where we really have some room to improve on the investor experience?

Rekenthaler: Well, I think if we can talk about bright spots, and we just step back and look at this from the big picture, there's very little mutual fund scandal in a big way globally in the sense of what happens with hedge funds. Mutual funds aren't just sort of disappearing one day, and it turned out that they were a fake entity and the company that's running the mutual fund disappears, and now that the price goes to zero.

I've tracked hedge funds over the years and followed hedge funds; there are a lot of hedge funds that go to zero in a day. It wasn't just the Madoff funds. There were many smaller funds. You don't see that in the fund industry. The fund industry has rules set up for the custodians, so that the custodian is separate from the investment company and the regulations and so forth.

So, the bright spot is--and the reason why there's no failing grade, and almost every [country] gets B's and C's--is these things do run the way that they say they're going to run, and for the financial services industry, they are remarkably scandal-free and clean.

So, areas that they can improve? Well, they certainly could become cheaper. The U.S. does well in this. We'll talk about that, but many countries have funds that are a lot more expensive than in the U.S., and while scale is a part of the reason why--because they're larger--it's also cultural. There are other things they can do to lower their costs. So, costs are a big issue.

And disclosure is also a practice that varies widely across the globe. There are countries where you can't even get the portfolio holdings, you are not even permitted to know what it is that your fund invests in. So those are areas that [could be improved]--making the investment process less opaque.

Stipp: And you mentioned the U.S. How did we, here at home, how did we score? What grade did we get?

Rekenthaler: The U.S. has its highest score of A, as it has had three years in a row, which we have been accused at times of being a U.S.-based firm, so that's why those results occur. And … I'm willing to accept some of that, that there's some U.S. viewpoint that comes through in how the questions are framed.

On the other hand, no matter how you look at it, the U.S. has the lowest-cost funds across the globe. And the U.S. has the most disclosure and best disclosure across the globe. [However,] we don't actually lead in portfolio holdings, disclosing once a quarter as a requirement and once a month for many funds, with a lag. There are actually some countries that do better.

But many other details--who the portfolio manager is--that is still information that's inconsistently given across the globe, but an absolute standard here [in the U.S.]. And when the portfolio manager started and how the portfolio manager was compensated, the compensation structure, and how much money does the portfolio manager, or do the portfolio managers, have in the fund--that sort of information. And those are our two biggest [categories]--there's 60% of the score between fees and disclosure. And the U.S. is just a runaway winner in those two areas.

Stipp: So, fees and disclosure were scoring very well. Overall, we got an A. But one area we didn't do as well is in regulation and taxation. The U.S. got a C there. What caused that score to be a C? What didn't we do better? What factors would need to be present for that grade to be a B or an A?

Rekenthaler: Well, two big things are; one, the U.S. has multiple regulators. There is the NASD [now FINRA], a self-regulatory agency watching over fund advertising. There is the SEC. There are state regulators. In our view and our experience, … it's better to have a single regulator rather than have things fall between the cracks or having two or three regulators all looking at an aspect and it's more costly and just more of a hassle to the organization to … deal with multiple regulators. So sometimes you're dealing with two or three regulators--sometimes zero. And in our view, one would be the better number. So, multiple regulators: It would be nice if we cleaned up that front.

And the other area is on taxation. … One thing we do is, we take a hypothetical investment of $100,000 over a five-year period, and we run it through a tax model, and see how much people would pay in taxes. It's the same investment in 24 countries with the same results. And what's the tax bill? The U.S. has among the very highest tax bills.

Most countries do not do what the U.S. does, just for one example, where every year a fund is required to pay out capital gains on the realized capital gains in the portfolio. In most cases [across the world], you pay capital gains on a fund when you sell the fund--if you pay capital gains at all (there are certain countries where you wouldn't pay capital gains). You don't get hit with a capital gains tax bill if you're just holding the fund and not making a trade yourself. So, our tax policies are not particularly favorable to fund investors.

Also something worth pointing out, … this is meant just solely from the perspective of the fund investor. It's not a political document. We're not trying to say what best tax policies are for countries worldwide. We're saying that from the perspective of a fund investor, paying fewer taxes, less in taxes, is better. It's just that simple. And from that perspective, the U.S. has not scored well, and a lot of the Asian countries in contrast tend to score very well.

Stipp: John, some really interesting insights from a very important study. Thanks for joining us today and giving us the key takeaways.

Rekenthaler: Thank you, Jason, and it's 150-page report or so, so we've got 149 more to discuss.

Stipp: Well, that report is available on All of our readers can check it out and get all the details there. Thanks again for joining me.

For Morningstar, I'm Jason Stipp. Thanks for watching.