Takeaways from Our Stewardship Grades
We've learned a few things about mutual fund governance.
Morningstar's Stewardship Grades for funds are nearing their third birthday, and since the grades' inception, we've learned a lot about how to evaluate funds' care for shareholders' capital. We launched the grades in August 2004 to help investors make better investment decisions in the wake of the mutual fund industry's market-timing scandal. We wanted to shine a direct light on funds that employ the industry's best stewardship practices and consistently act with shareholders' best interests in mind. Equally important, given the potentially severe consequences of weak stewardship, the grades also point to funds that fall short.
We consider five areas when determining a fund's grade: corporate culture, board quality, manager incentives, fees, and regulatory issues. In addition to relying on our analysts' knowledge of various fund companies based on years of experience with the people and practices of the firm, we use scores of data, SEC filings, interviews with management and fund boards, and fund-company visits to evaluate each of the five areas and arrive at an overall grade.
In grading about 1,200 funds over the course of three years, we've noticed some interesting trends. The industry's governance practices have evolved significantly in the past three years, so we plan to refine our Stewardship Grade methodology to continue to reward best practices and to further recognize those firms that go above and beyond the industry standard. For example, we'd like to better recognize fund boards that have elected independent chairmen in recent years. Ultimately, as before, we want to do our best to identify the industry's top stewards and to continue to identify the laggards. We're putting the finishing touches on the refined methodology now, and we'll share the changes with you in mid-June. In the meantime, here are some key conclusions we've drawn from the grades:
Lesson One: Disclosure Is the Shareholders' Friend
When we started this initiative, much of the information we now use to assess manager incentives was not publicly available, making it difficult to assess which managers were best aligned with shareholders. Only in February 2005 did the Securities and Exchange Commission start requiring funds to disclose the factors that dictate a fund manager's pay and how much money (within some set ranges) the fund manager has invested in the fund he or she runs.
As you might imagine, this disclosure has been enlightening. Some fund shops pay their management teams primarily for their ability to deliver strong relative and absolute returns to shareholders--a best practice, in our view. But others disappointingly pay based on asset or profit growth, both of which may not be in fund shareholders' best interests because bloated funds sometimes underperform.
We like the way the Davis and Selected American funds describe their manager compensation plan in the funds' Statement of Additional Information. There, fund managers' bonus payments vest after a specified period (usually five years), but the managers' bonuses can be reduced should the funds lag their peers during the period.
Meanwhile, disclosures describing pay plans at other shops have left a lot to be desired. Fidelity, along with many of its peer firms, leaves out some key details of its compensation plan, making it tough to determine whether fund managers' own financial interests are aligned with shareholders'. These firms comply with the letter of the disclosure law, but not with its spirit.
The newer disclosure requirements also tell us which fund managers are invested alongside their shareholders. For example, most managers at Royce, the small-cap fund shop, have more than $1 million invested in the funds they run, with firm founder Chuck Royce owning shares worth more than $50 million. Meanwhile, managers at other firms, including AllianceBernstein, Columbia, and JP Morgan, have spottier levels of investment. We think managers who invest in their funds demonstrate conviction in their security-selection process and are more likely to act in long-term shareholders' best interests.
Another area of new and enhanced disclosure relates to the job that mutual fund boards are doing. Boards are now required to discuss in the fund's annual report why they renewed the contract between the fund and the fund company. (Although it rarely happens, boards can fire a fund's advisor if the trustees are unhappy with the quality of management or the fairness of fees being charged.) Some boards, including the trustees who oversee the Putnam funds, have provided shareholders with detailed descriptions of the process they go through before approving the contract, including evaluating a fund's fees, investment process, and investment results. The contract-renewal disclosure can give shareholders a better peek into whether their fund's board is asking tough questions or rubber-stamping the advisory contract each year.
In the case of Putnam Voyager (PVOYX), the Putnam fund board gave an in-depth description of its fee analysis of this fund, and the group noted that the offering's performance had been subpar in recent years. But the trustees said they were satisfied with Putnam's attempts to turn things around, including changing the management team and tinkering with its investment process. Shareholders of this fund may not be as patient given the fund's bottom-quartile three- and five-year returns, and the fund board's disclosure that it's sticking with Putnam (and not sending the fund's assets to a subadvisor) may make it easier for a shareholder to decide whether to stay put or move on.
Lesson Two: Independent Boards Are Best
Funds are structured as corporations with boards of directors who are charged with looking out for the individual shareholder, but for the typical fund owner, it's hard to know whether the fund board is a spectator, along for the ride, or a true advocate for shareholders. Morningstar mutual fund analysts often talk with boards of directors about their approaches to fund governance, but we aren't flooded with invitations to attend closed-door fund-board meetings. That's why we look at four factors that we think are most relevant when evaluating a board from the outside. We look at the degree to which the fund board is independent of the asset manager. We also consider whether the board members invest in the offerings they oversee. Finally, we examine the directors' workload measured by the number of fund they're overseeing and whether directors consistently act in shareholders' best interests.
After three years of weighing these factors and talking with boards about how they do their jobs, we've become more insistent that boards be run by independent chairmen and be made up of at least 75% independent directors. As we told the SEC in March, we think it's impossible for interested chairmen to set aside the conflicts of interest that arise when a fund-company executive runs the fund board. That concern is especially pressing when it comes to setting fund fees because the asset manager benefits from higher fees and shareholders benefit from lower fees.
Academic research has shown that funds governed by highly independent boards tend to oversee cheaper offerings, and Morningstar's own research has shown that the cheaper the fund, the more likely it is to outperform its peers. Therefore, we think it's reasonable to conclude that more independence on a fund's board makes it more likely that the fund will deliver stronger returns.
Lesson Three: Corporate Culture Is the Heart of the Stewardship Grade
As we've studied the five sections of the Stewardship Grade, we've increasingly found that a firm's corporate culture does the most to dictate whether its funds serve investors well. In evaluating a firm's corporate culture, we look at whether its culture is sales-oriented or investment-oriented. For example, we prefer firms that don't launch trendy funds that are ill-timed and hard for investors to use, such as an energy-focused offering in 2005 or a real estate fund in 2006. We also think that advertising a fund's short-term performance is a poor practice because it can give investors the false impression that those results are repeatable. We also like firms that treat their shareholders as owners and candidly explain in semiannual and annual reports what went right and wrong with a fund's investment process. Looking at the stability of a fund company's own investment personnel can be telling. We've found that the healthiest cultures are able to attract and retain strong investors over time. Therefore, we carefully look to see whether fund managers and analysts at a firm tend to spend their careers there or whether manager turnover is commonplace.
Anecdotally we can see the relationship between an impressive culture and a strong overall Stewardship Grade, and the data bear a similar conclusion: Of the dozens of funds that earn "excellent" marks for culture, only three received Stewardship Grades below a B, indicating that the funds also tend to score well in the other areas of the grade.
If you'd like to see how well the funds in your portfolio score on stewardship, Premium Members of Morningstar.com may click here. We describe what we've learned about specific funds' governance practices in the text associated with each grade.
Laura Pavlenko Lutton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.