These Funds Have Standout Stewards at the Helm

Morningstar's recent August fund-flow data strongly point to a continued investor flight from actively managed funds. The large-growth and large-value categories (where index funds make up a smaller portion of assets) have suffered a loss of $35.6 billion in outflows for the year to date, versus a much, much smaller $309 million year-to-date outflow in the large-blend category (which is home to the most popular index funds). In addition, continued outflows from the actively managed American Funds lineup underscore that active management is currently out of favor. 

Despite mounting evidence of skepticism over active management, a carefully selected actively managed fund can pay off for investors who choose the right managers at the right shops. When screening for investor-friendly funds,  Morningstar's Stewardship Grades help cut to the chase by wrapping up many aspects of corporate governance into one score in order to identify fund firms that do a good job of aligning their interests with fundholders'.

Stewardship Grades are based on information compiled from public filings and qualitative data gathered by Morningstar's fund analysts. They encompass five main variables that are each weighted differently: corporate culture, board quality, manager incentives, fees, and regulatory history. Points are tallied across all components to arrive at a Stewardship Grade, with the maximum score being 10 points. (To read more about how Morningstar calculates Stewardship Grades, click here.)

Investors should note that a fund's Stewardship Grade has no direct bearing on its Morningstar Rating, which is strictly quantitative and based on historical return and risk. But the two data points may in fact be closely correlated. An independent, academic study by Cornell University professor Jay W. Wellman and SUNY professor Jian Zhou suggests significant correlation between mutual fund governance and mutual fund performance. Using Morningstar Stewardship data as well as data from fund flows, Wellman and Zhou found that funds with higher Stewardship Grades outperformed those with lower grades, with board quality and fees having the most significant impact on a fund's performance.

With that study in mind, we used the  Premium Fund Screener to look for actively managed funds with Morningstar Stewardship Grades of A that were open to new investors. Along with exemplary Stewardship Grades, we required that funds have ranked in the top quartile of their peer groups for both the trailing three-year and 10-year periods. Finally, we limited our search to managers who have been at the helm for at least 10 years. As of Sept. 28, 2010, the screener turned up 11 standout stewards, three of which we highlight below. Premium Members can run the screen by  clicking here.

 American Funds American Mutual (AMRMX)
Expenses: 0.66% | Minimum Investment: $250 | Load: 5.75%
This conservative large-value fund is a strong steward. The fund family as a whole boasts extraordinarily low manager turnover, and one of this fund's managers, James K. Dunton, has more than 45 years of experience. American pays performance bonuses to analysts based on one-, four-, and eight-year records, with an emphasis on long-term results that both promotes and encourages patience for any contrarian picks to pay off. Low fees coupled with some of the lowest equity turnover rates in the industry make this fund a reliable pick for conservative, cost-conscious investors who also ascribe to the buy-and-hold ethic.

 Royce Special Equity Investment (RYSEX)
Expenses: 1.17% | Minimum Investment: $2,000
For the conservative and patient investor, this fund has a lot to like. It has had streaks of choppy returns during market rallies, but manager Charlie Dreifus' defense of capital during market gloom was rewarded in the long term. And in 2008, Dreifus was named Morningstar's Domestic-Stock Manager of the Year. This small-cap fund's only blemish amid generally standout stewardship is Royce's C grade for board quality. One concern that we have is that Royce's board has let some funds grow too large, and that given the increase in assets, fees for some of its funds could stand to be lowered. Still, this particular fund, with an expense ratio of 1.17% being in the lowest quintile among direct-sold small-cap offerings, remains a truly cost-efficient investment.

 T. Rowe Price Spectrum Growth (PRSGX)
Expenses: 0.83% | Minimum Investment: $2,500
This fund of funds Analyst Pick has an impressive long-term record that has beaten the S&P 500 by an average of more than 2 percentage points during every five-year rolling period since 1998. The fund is an effective one-stop shop for diversification in your portfolio with its inclusion of small- to large-cap, value to growth, and domestic to international funds. Although strong on the stewardship front, we would like to see more independence in the fund's board of directors. The board's chairperson, Ed Bernard, is also a T. Rowe executive and the vice chairman of T. Rowe's corporate board. But with its reasonable fees, exceptional corporate culture, managers with sizable stakes in fund shares, and no regulatory issues, T.Rowe Price holds true to its long-held reputation as a center of investing excellence.