How Do the Best Funds Treat Shareholders?

As assets in mutual funds have dipped over the past year, the fund business has gotten a lot tougher. There may be more temptation for funds to slight shareholders by hiking fees, rolling out aggressive sales tactics, or cutting key investment personnel with the hope of improving revenue. That's why Morningstar Stewardship Grades for mutual funds are just as relevant as ever.

The Stewardship Grades evaluate how well funds care for shareholder capital and are distinct from other ratings, including the Morningstar Rating (aka the star rating). We evaluate funds across five different areas--corporate culture, fund board oversight, manager incentives, fees, and regulatory history. Based on the funds' scores in each section, they each earn an overall grade. As is the case in school, funds earning A's are at the head of the class, while those earning D's and F's have a lot of work to do.

It's important for several reasons to consider stewardship when making an investment decision. First, funds that earn top Stewardship Grades are focused on treating shareholders well. We think investors will have a better experience with their funds over the long term if they're treated like owners--not like just another dollar in the door. More importantly, funds with higher Stewardship Grades tend to outperform those with lower grades, according to a new study by two academics who have no affiliation with Morningstar.

In recent weeks, Morningstar's analysts have updated the Stewardship Grades for hundreds of mutual funds. To find out which funds looked strong--and weak--in this latest round of updates, read on. If you'd like to read more about why a fund earned the grade that it did or find how a fund you own scores, click  here.

Best Practices on Display
Among the funds that we've re-evaluated recently, the American Funds earn the highest marks. These broker-sold giants have industry-leading traits when it comes to corporate culture. The firm has a well-established investment process that's executed by money managers who are talented investors and stay with the firm for the long haul. The firm's manager-retention rate is one of the highest in the industry--managers rarely leave the firm, except to retire.

In the past, we've been critical of the American Funds' girth, and we're still concerned that the funds are so big that they'll become indexlike. But we've grown more comfortable with the firm's ability to manage those assets, in part because the American Funds continue to follow their time-tested strategy of buying stocks and bonds that their competitors are selling and espouse a long-term investment horizon. The funds have other strong stewardship practices, including low fees, independent leadership of its fund boards, and a pay plan for its fund managers that emphasizes long-term performance. All told, most of American Funds' offerings earn A's for stewardship.

Diamonds in the Rough
Another group that scored well recently is the Diamond Hill funds, which are run by an Ohio-based boutique. These funds also get A's for corporate culture because serving shareholders well is a central theme in the investment process, shareholder communications, and fund board structure. The firm is known for its thorough, candid letters and presentations that it publishes for shareholders and financial advisors. We're also pleased to see that the fund managers have made considerable investments in the offerings they oversee.

The Diamond Hill funds also employ best practices when it comes to governance. Its fund board is completely independent of the asset-management company, and the directors are paid in fund shares to better align their own financial interests with those of fund shareholders. Like the American Funds, offerings in this family earn A's for stewardship.

Middling Grades for Many
Most of the funds earning Stewardship Grades from Morningstar get average marks, and that's the case for funds in the AllianceBernstein, Fidelity, Janus, and Oppenheimer families.

As my colleague Katie Rushkewicz wrote last week, we had been more bullish on AllianceBernstein's renewed focus on serving shareholders well under now-retired CEO Lew Sanders. But we're taking a more cautious stance with new leadership at the helm and have lowered the funds' corporate-culture score to a C from a B. We'd like to see tangible evidence that the new CEO, Peter Kraus, is keeping the firm focused on serving shareholders well. Most funds in this family now earn C's for stewardship.

Fidelity is another firm that has undergone some change in recent years, most notably expanding its analyst staff and creating a career-analyst track for those researchers who don't want to hop around to different sectors and eventually run a diversified fund. This push for more analytical resources is in keeping with Fidelity's history of attacking its weaknesses. More isn't always better, though, and the analyst build-out hasn't been a resounding success yet. The firm's ultracompetitive culture can produce good results for fund shareholders, though we take issue with the frequent manager changes on its funds, its interested board chairman, and, in many cases, the weak manager ownership of fund shares. The typical Fidelity fund earns a Stewardship Grade of C.

Trying to Right the Ship
Also in the C camp are funds offered by Janus. The Denver-based firm has had its share of drama in recent years, as several longtime managers have left, the analysts have gained prominence in the investment process, and the firm as a whole has become more risk-aware. The firm also has changed its distribution focus to cater to advisors rather than individuals. While the Janus funds certainly have some pluses when it comes to stewardship--its managers invest significantly in fund shares, its fund board is independent, and its fund expense ratios are cheap--many recent changes at the firm seem to have been motivated by Janus' concerns about its own bottom line versus that of its fund shareholders.

And then there's Oppenheimer. Funds at the firm got fairly strong grades for stewardship in past years, but we were disappointed by the way that Oppenheimer handled its bond-fund lineup during the 2008 market sell-off.  Oppenheimer Core Bond (OPIGX), the firm's flagship fixed-income fund and a key holding in target-date and 529 college-savings plans, held risky securities that led to huge losses for shareholders. The firm did a poor job communicating these risks to shareholders, and the losses have been devastating to investors. That breech of good stewardship is the main reason we have lowered the funds' corporate-culture score to a C from a B. Overall, the funds in the family earn C's for stewardship.