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Mutual Funds That Make the Grade

Use this screen to find offerings that get A's for stewardship.

Trust is critical when investing, and not all fund firms have proved worthy fiduciaries for investors' hard-earned money. Our team of fund analysts hit the pavement, search fund filings, and keep good records of fund companies' histories to try to distinguish between top fiduciaries and shine a light on those that have failed to hold up their end of the bargain. Morningstar's Stewardship Grades can be a useful tool for scouting out the firms that have done an admirable job of putting fund shareholders' interests ahead of their own.

This screen is a snap to create with the Premium Screener. To focus in on good stewards, we limited our search to funds that earned an A grade for stewardship. Then to tidy up the list, we searched for "distinct portfolios only," which limits the results to one share class per fund. We also required that the funds be open to new investments. As of March 25, 2009, 67 mutual funds passed this test.

While all these funds earn A's overall, some funds on this list are standouts in certain areas. Five components make up each of our Stewardship Grades: corporate culture, board quality, manager incentives, fees, and regulatory issues. To view the full list, click  here.

We'll briefly examine each component of our Stewardship Grades and highlight some of them.

Corporate Culture
This component of the grade rewards fund shops that build an environment centered on good investing and where investment considerations rank well ahead of marketing and sales. A handful of FPA and Royce funds made the list, and both firms are standouts on the corporate culture front. Both firms are known for their ability to attract top investment talent, and portfolio managers spend their careers working at these firms. And although Bob Rodriguez, CEO of FPA, will leave the firm for a one-year sabbatical starting Jan. 1, 2010, we expect that the deep bench of managers and analysts currently backing him up will remain in place to handle the day-to-day management of the funds and the firm. A careful succession plan, which involves selecting fund managers who are well attuned to the firm's corporate culture, is a key to success here.

For Rodriguez and Chuck Royce, president of the Royce Funds, strong long-term performance is paramount. Instead of trying to put up hot short-term returns and gather assets, both FPA and Royce have frequently closed funds to avoid asset bloat. And investors in these firms' offerings also benefit from candid shareholder communications, which clearly lay out the successful and unsuccessful aspects of each investment strategy. Likewise, Royce's Web site is chock-full of useful information and frequent commentaries that help fundholders keep their expectations in check.

Board Quality
In general, the more independent members on a fund board, the better. We like to see 75% of board members be independent (as well as the fund board chairman) because there is less risk of conflicts of interest when it comes to fund fees and asset levels that contribute to the fund company's bottom line. For example, large-blend fund  Longleaf Partners (LLPFX) gets an A here because six of its eight board members are independent, including the chairman. The board members generally have financial/investing backgrounds, and each board member has more than $100,000 invested in the firm's funds, which demonstrates their commitment to the funds' long-term performance. In addition, the board has prudently supported closing funds before their asset levels become bloated.

Manager Incentives
Let's face it, a portfolio manager's pay has an effect on that person's actions. We like to see managers paid on factors that are in line with the fundholders they are trying to serve. To that end, portfolio managers who are compensated based on long-term performance as well as those who invest heavily in their firm's funds score highly here. Diamond Hill funds are good examples, given that manager compensation is not explicitly tied to assets under management. Portfolio managers instead receive a base salary plus incentive compensation that is tied to five-year rolling pretax performance relative to the funds' benchmarks. This makes sense given that the firm's managers invest using a process that models firms' intrinsic values based on five-year estimates of their cash flows.

Managers who invest heavily in their own funds, including managers Ric Dillon and Chuck Bath, also help build shareholder trust. Dillon and Bath manage and/or comanage the three funds on this list:  Diamond Hill Large Cap (DHLAX),  Diamond Hill Long-Short (DIAMX), and  Diamond Hill Small Cap (DHSCX). To illustrate the type of investment that we consider to be a sign of true commitment to shareholders' best interests, Dillon has more than $1 million invested in Diamond Hill Long-Short and between $100,000 and $500,000 invested in Diamond Hill Small Cap. Bath has more than $1 million invested across the firm's fund lineup, with between $500,000 and $1 million in Diamond Hill Large Cap and between $100,000 and $500,000 in Diamond Hill Long-Short.

Another issue that falls under the manager-compensation component of the grade involves hedge funds. Diamond Hill runs two hedge funds, which normally raises red flags in terms of conflicts of interest. Because hedge funds have more-lucrative fee structures than mutual funds, this could result in the firm's best ideas going into the pricier funds to the detriment of mutual funds. However, the firm has a policy in place to avoid this dilemma. For fund managers who own stakes in the firms' hedge funds, they must also buy a stake in at least one of the firm's long-only funds.

Unlike the other sections of our Stewardship Grades that depend heavily on firmwide policies, funds are graded individually for their fees. Mid-cap growth fund  Columbia Acorn (ACRNX), for example, charges 0.76% annually, which puts it in the cheapest 20% of other broker-sold funds in its category and a high score in this section. Of course, Vanguard is a perennial standout on the fee front, and T. Rowe Price boasts many funds that are among the cheapest in their respective categories.

Regulatory Issues
With investment scandals all over the news, it seems an appropriate time to point to fund shops that have had clean records with regulators and a real culture of compliance. The majority of the firms on this list haven't had any major brushes with regulators in the recent past or during the market-timing scandal that erupted earlier this decade. Some shops, including Royce, were proactive in combating this problem in the earlier part of this decade by imposing redemption fees to shares held for less than 180 days to deter market-timers. Fair-value pricing, which is employed at  Dodge & Cox International Equity (DODFX), also discourages market-timing activities that harm fundholders.

To conclude, we'd note that strong stewardship didn't save funds from 2008's dramatic market sell-off, but we certainly think that it is something that investors should strongly consider when selecting a mutual fund to invest in for the long haul.

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Karin Anderson has a position in the following securities mentioned above: DODFX. Find out about Morningstar’s editorial policies.