Introducing the Morningstar Stewardship Grade for Funds

For many investors, the search for an investment idea begins with familiar signposts, such as past performance and risk level. While these factors are important when considering whether or not to buy a fund, they don't take into account crucial intangibles. For instance, a fund's historical risk/reward profile doesn't tell you whether the interests of a management company and fund manager are aligned with those of the fund's shareholders. Nor do basic risk measures tell you anything about a fund firm's corporate culture. For example, when looking at a particular fund company, it's important to ask whether the organization, as Jack Bogle has put it, values salesmanship over stewardship. Does the firm take its responsibility to fund shareholders seriously and actually put their interests first?

Morningstar analysts have pondered these very questions since we began evaluating mutual funds in 1984. Our assessment of a firm’s commitment to fund shareholders has frequently informed the investment recommendations we've made over the years. For instance, we've criticized boards for not safeguarding the interests of investors with fund closures and liquidations, questioned the value of many fund mergers, railed against high expenses, and complained about management turnover. Of course, much of this information has been diffused across funds and not presented in any systematic way. Now, however, we're taking the next step and presenting this research in a uniform fashion that will make it easier for investors to compare the corporate-governance track records of funds they own or are considering buying.

Today marks the debut of Morningstar’s new Stewardship Grade for funds*. (We're initially launching this feature with grades for 500 of the largest funds, and we will expand the number of funds with grades in the coming months.) The Stewardship Grade serves as a handy way to assess key intangibles--such as the quality of a fund's board of directors or a fund firm's corporate culture--that can make the difference between a great investment and one to avoid. The grades, which will range from A (best) to F (worst), are not meant to be used in isolation or as simplistic buy/sell signals. Rather, they represent yet another valuable addition to our suite of investing research and tools, alongside our written Fund Analyst Reports and Morningstar Rating for funds.

The letter grade assigned to each fund is based on the fund’s score in five key areas. Following is a brief synopsis of those components, each of which is weighted equally. For a more in-depth explanation of the methodology behind our Stewardship Grade assignments, click here. (A fund's grade is located under the Stewardship Grade tab in the left-hand navigation section of its Fund Report. For example,  click here to see Vanguard 500 Index Fund's Stewardship Grade.)

Regulatory Issues: This one is fairly straightforward. We examine each firm's record to determine if it has run afoul of regulators in the past three years. We also look at the gravity of the allegations and the subsequent reforms that the firm has undertaken. For example, while Strong and AllianceBernstein both get dinged for their role in the fund scandals, we think the latter has done a far better job of addressing its problems than Strong has. As such, AllianceBernstein scores higher than Strong on this factor.

Board Quality: Our analysts have spent a great deal of time pulling together this information because we think the quality of a fund's board of directors is of paramount importance. For far too long, fund boards have looked the other way as investment-management firms have launched lousy funds, hiked expenses, or left underperforming managers on the job. For example, we think boards such as PBHG's could be doing a better job. It allowed expenses to be raised at  PBHG Clipper Focus  , despite sizable growth in assets.

Because boards are in place to represent fund shareholders' interests, we're taking a close look at factors such as the number of funds that directors oversee, the relationships between directors and fund firms, and the performance of trustees in looking after fund shareholders' interests. We also examine whether trustees are investing alongside fundholders. For example, we like that all ICAP board members are paid in fund shares.

Manager Incentives: Over the past few months, we've been asking fund companies to complete a survey detailing the structure of fund managers' pay as well as the level of their investment in fund shares. We have not asked for specific salary figures; in our opinion, the structure of a manager's compensation--bonus in particular--is more important than the dollar amount of his or her pay. We believe that performance incentives can have a strong influence on the way a fund is run. A fund manager who is paid to beat an aggressive benchmark over a one-year period, for example, might be inclined to take much bigger risks than he or she otherwise would.

We also believe managers should eat their own cooking by investing in either the funds they run or other offerings run by their firm. Why? Because fund share ownership is an important reflection of whether a portfolio manager has conviction in his or her own process. Managers who invest alongside fund shareholders are also more likely to pay much closer attention to issues like expenses and taxes than ones who do not. We don’t believe it’s a coincidence that firms like Longleaf Partners, which requires that all employees invest in Longleaf’s funds, have shown themselves protective of fund shareholders’ best interests. And while it's true that there's a dearth of evidence linking manager investment in fund shares to superior performance, such a study wasn't even possible until now because the data was unavailable.

Expenses: The amount that a management company charges fund shareholders often speaks volumes about the priority the firm accords the interests of fund shareholders versus those of company stakeholders. That's why we examine whether fund investors are getting a good deal or the short end of the stick. For example, we've recently been critical of fee hikes at Evergreen that we thought were egregious. We're interested in seeing not only how a fund's expenses stack up relative to its peers, but also at trends in expenses to gauge whether a firm is appropriately passing on economies of scale to a growing fund's shareholders. Importantly, the scoring for this factor is within category and within distribution channel because we want to compare apples to apples.

Corporate Culture: No, we're not talking about dress codes or broadly assessing how a firm operates. Rather, we're focusing on how shareholder-focused management is by looking for tangible evidence that a firm has a deep-rooted understanding of its role as a fiduciary. This is the most subjective component of the grade by virtue of the sheer number of factors that can influence the depth of a firm's commitment to its fundholders.

Our analysts have spent a considerable amount of time evaluating criteria such as the quality of shareholder reports, a firm's willingness to close funds at appropriate asset levels, and the pattern of new fund launches. We examine how fund companies deal with these issues to gauge whether the long-term interests of fund shareholders have consistently been placed front and center--where they belong. We've also taken a close look at firms' usage of redemption fees and the ability to retain key personnel. Firms that embody these principles, such as Davis Advisors, score highly, while firms that we think fall short, such as Van Kampen, score poorly.

* The Morningstar Fiduciary Grade for funds was renamed the Stewardship Grade for funds as of Feb. 7, 2005.