Few Funds Ace Morningstar's Stewardship Test

Morningstar relaunched its Stewardship Grades for funds today under a revised methodology, which was designed to reward the industry's best stewardship practices. As a result of the changes, it's tough to get a top grade. In fact, we graded more than 1,000 funds under the improved methodology, and just two funds earn perfect scores for stewardship and only 6% get A grades.

Why is it so difficult for funds to earn a top Stewardship Grade? The changes we've made to our methodology are a key part of the answer. To be sure, the five main tenets of the grade haven't changed. We still look at corporate culture, fund board quality, manager incentives, fees, and regulatory history when assessing whether a fund is a good caretaker of capital. But the improvements we made to the methodology are designed to reward funds that consistently put shareholders first, and funds that aren't as shareholder-friendly now receive lower grades.

Spotlighting Corporate Culture
For example, we now attach twice as many points to the corporate-culture portion of the grade. Corporate culture is worth as much as 40% of the total grade, up from 20%, because we think that the underlying culture of a firm gets at the heart of how well a fund company stacks up as a steward of investors' capital.

Firms with the strongest corporate cultures consistently place fund-shareholder interests first. And we've found that a fund firm's corporate culture sets the tone for the other four areas of the grade. We've noticed that funds with fundholder-focused corporate cultures usually have fund-performance-based manager-compensation plans, strong fund-manager investments in the funds, and reasonable expense ratios on the funds. Take T. Rowe Price, for example. Many of its funds earn overall A grades because the firm's corporate culture puts fund shareholders first, its manager-compensation plan hinges on long-term performance, and most of its funds are reasonably priced.

On the flip side, funds supported by weaker corporate cultures--those that put asset-gathering and business interests ahead of caring for current investors--usually show poorly in other areas as well. Federated's funds, for example, earn D grades for corporate culture, and the firm's manager-compensation plan doesn't stress strong long-term performance, its fund managers rarely invest in the funds they manage, and fees on some of the funds are far too high, in our view. The Federated funds' overall Stewardship Grades are mostly D's and F's.

Independent Watchdogs Are Best
Another area where some funds lost credit toward their overall Stewardship Grade is the board-quality section. To receive full credit for board quality, we now require fund boards to be led by independent chairmen and have at least 75% independent directors on the board. We're placing more emphasis on board independence because, as we've noted before, we think highly independent boards are best able to address the conflicts of interest between the asset-management company and fund shareholders. This conflict is particularly relevant when it comes to negotiating fund fees and approving contracts relating to fund management and administration.

Funds in the Fidelity family, for example, all lost some credit in the board-quality section of the grade because the chairman of its fund board, Ned Johnson, is also an executive and primary owner of the advisor to Fidelity's funds. In the past, the fund family has been slow to close some of its most successful funds, and we wonder whether an independent chairman would have been a stronger advocate for keeping assets in check to protect the funds' existing shareholders. Johnson directly benefits from asset growth because it leads to more revenue at Fidelity. Most Fidelity funds get C's under the new methodology, whereas they previously earned mostly B's.

The final change we made in the board-quality section was to place more emphasis on whether fund boards are serving investors well. To accomplish this, we are no longer evaluating a fund board's workload. (Previously, we deducted credit from fund boards that oversaw too many offerings, in our view.) At the end of the day, the board's actions matter most to shareholders, so we're looking for hard evidence of board activism. This change has worked in favor of some fund boards that serve shareholders well despite having a large number of funds to oversee, including Vanguard's fund board. But in other cases, fund boards that govern relatively few offerings, but still have not negotiated low fees or pushed to close bloated funds on behalf of shareholders, lose credit. The board overseeing the Weitz funds is one we wish would be a tougher negotiator on fees.

Fees Predict Performance
We also made a notable change to the fee section of the grade. We now focus exclusively on a fund's current cost relative to its peers. Previously, we looked at both the fund's actual cost and a fund's fee trend over time to determine whether the fund has passed along economies of scale to fund shareholders via lower fees as assets in the funds have grown. We still think it's important for fundholders to benefit from economies of scale--in fact, we think it should be a given that a fund's expense ratio would fall as assets in the fund grow.

At the end of the day, however, Morningstar's research has shown that fund fees are one of the most reliable predictors of performance. The lower the expense ratio, the more likely it is that a fund will outperform over the long haul. Thus, the funds that fall in the cheapest quintile of their peer group receive A's for the fee section of the Stewardship Grade, and funds that are more expensive than 60% of their peers receive F's. Some funds' higher fees cost them credit in this section. In fact, about 13% of the funds we grade earn F's for fees that are higher than their peer group's norm.

Regulatory Run-Ins Reduce Grades
We also made a notable change to the regulatory-history section of the grade. We think fund shareholders should--at a minimum--expect their funds to comply with industry regulations. Therefore, funds can no longer earn points for simply complying with regulations and following the law. Instead, firms that have had run-ins with regulators in recent years can have as much as 20% of the possible points docked from their overall Stewardship Grade scores. Those funds that haven't always followed the law haven't consistently put shareholders first and therefore receive lower Stewardship Grades. Funds offered by families that were caught up in the 2003-04 market-timing scandal all have had their Stewardship Grades scores reduced because of their breach of shareholder stewardship. AIM, AllianceBernstein, Janus, and Putnam are examples of firms that have had serious regulatory violations in recent years.

Wondering how your funds score under our new Stewardship Grade methodology? Premium Members to Morningstar.com can click a list of the funds we've graded thus far. Nonmembers can give Premium a try for 14 days free of charge by clicking here. If we don't cover your fund yet, please check back because we'll be adding to our coverage in the coming months.