Why Some Strong Stewards Don't Earn Straight A's

Nobody's perfect. Everyone knows that clich� applies to people, but it might not be as obvious that it also holds true for the mutual fund industry. The few fund shops that score highly on all five of our Stewardship Grade components (regulatory compliance, fees, board quality, manager ownership and compensation, and investment culture) deserve accolades for their shareholder-friendliness, but most still fall short of best practices in certain areas. Below we highlight where a handful of fund shops with reputations for stewardship excellence could stand to improve. Of course, these firms are good stewards overall and we recommend a number of their proven offerings. But very good isn't synonymous with flawless, so approach the industry's best with the same discerning eye often reserved only for the less renowned.

First Pacific Advisors
On most counts, First Pacific Advisors is an exemplary steward of shareholder capital. The small shop, home to top performers  FPA Capital  and  FPA Paramount , focuses on investing, not marketing, and works hard to be forthright with investors. It refuses to pay for brokerage shelf space with shareholder dollars and the fund managers emphasize long-term performance both in their investment strategies and in their candid shareholder reports.

But just because FPA sets the curve in most respects doesn't mean there is no room for improvement. We're disappointed by this otherwise spotless shop's manager compensation structure. Because the managers here are firm partners, they're compensated by fund fee revenues and the firm's profits. That gives managers a reason to put the firm's interests above those of long-term shareholders. Of course, if the managers were substantially invested in the funds they manage, most of our concern would be alleviated. But apart from CEO and fund manager Bob Rodriguez's sizable stake, many of the managers have surprisingly little skin in the game.

True, we haven't seen any evidence of questionable behavior here. FPA offers reasonable fees across its lineup and has executed a number of timely fund closes. All the same, we think a compensation structure based on long-term returns and substantial manager ownership would better guarantee shareholder-friendliness in the years to come.

Vanguard
Vanguard Investment Group is considered by many to be the industry's best steward of shareholder capital. Founded in 1974 by outspoken shareholder advocate John Bogle, the shop is shareholder-owned, and thus offers rock-bottom expenses on nearly all its funds and has an active and effective board of trustees. Plus, the firm has a strong compliance culture that's helped prevent the ethical slip ups that have plagued many of its rivals. Yet even this principled powerhouse has some areas it could work on. The bonuses of some of Vanguard's internal managers are based on three-year performance figures. We consider that sufficient and give the firm credit for the manager compensation portion of the Stewardship Grade, but it's curious the firm doesn't rely on longer periods, given its firmwide investment focus on the long term. Many of the firm's subadvisors also have disappointing compensation structures, basing pay off qualitative factors and performance periods no longer than three years. And we're surprised some of Vanguard's managers don't invest more in their own funds. At the beginning of 2006, Gerard O'Reilly, manager of the broad, and successful,  Vanguard Total Stock Market Index (VTSMX), had only between $100,001 and $500,000 invested in the fund, for example.

We also have a couple concerns about Vanguard's ETF efforts. Of course we like that its ETFs are cheap and broad-based. And to its credit, the firm has resisted the temptation to opportunistically launch trendy ETFs that lack long-term appeal. But we'd like to see the firm take the same vocal educational role with ETFs that it has historically taken with conventional mutual funds. ETFs are the latest investment craze and investors would benefit from a better understanding of their strengths and weaknesses. We're also mildly troubled by the firm's efforts to court financial advisors and hedge funds in the ETF space. That seems out of step with its well-deserved reputation for putting shareholders first. (To learn more about Vanguard's culture and stewardship, see our Vanguard Fund Family Newsletter.)

Parnassus
Parnassus Investments proves not even socially responsible fund shops are above reproach. The firm is careful to avoid industries such as alcohol, tobacco, and weapons manufacturing, and it proactively looks for companies that respect the environment, promote workplace diversity, and engage in philanthropy. In fact, in 2006 the fund shop hired an analyst dedicated to researching companies' social profiles. Unfortunately, the ethically minded firm has a few shortcomings of its own. In 1998 the SEC reprimanded firm founder Jerome Dodson for mispricing a security and misusing fund assets and reprimanded the firm for inappropriate use of soft dollars (the practice of directing brokerage business to certain firms in exchange for extra services or equipment, such as Bloomberg terminals). Given those regulatory run-ins, we pay close attention to the firm's compliance and oversight. We're pleased to see the firm hire outside legal counsel and appoint CFO Debra Early to serve as the chief compliance officer. But we can be sure only that one of the three independent trustees has more money invested in the funds than (s)he receives in annual compensation. That's discouraging, because we like to see board members act as shareholder advocates. Aligning their financial interests with those of the shareholders would help ensure they do that. Plus, we're disappointed the board members gave the go-ahead for three additional funds in 2005 without first ensuring the appropriate investment personal were in place.