Good Funds With Bad Pedigrees

We recently delved into the attributes of fund companies that earn either the best or worst Parent ratings. Morningstar's director of active fund research, Michael Herbst, counted himself among those investors who won't consider an offering from a Negative-rated parent, regardless of the fund's particular qualities.

That's understandable. If a fund is backed by a company that does not control costs or cannot retain top management, that fund may inevitably lose its edge, no matter how good it is today. As we demonstrated in a follow-up column, the factors that lead to a Positive Parent rating are also linked to superior fund performance.

So why ever choose a fund with a bad pedigree? A Negative Parent rating can be driven by factors that may not affect certain funds in a company's lineup. Sometimes specific positives can outweigh the negative in the background.

Take Charles Schwab's index offerings.  Schwab (SCHW) recently announced expense reductions that make its ETF index funds the cheapest around. The  Schwab U.S. Broad Market ETF (SCHB) now charges a rock-bottom 0.04%, edging past the 0.05% fee for  Vanguard Total Stock Market (VTI). Investors can open a brokerage account with Schwab for only $1,000 and trade the firm's ETFs commission-free. That provides a low-entry, cost-effective way to dollar-cost-average into the broad market.

You may well be wary. After all, Schwab Total Bond Market lagged its benchmark miserably during the financial crisis because it was overloaded with mortgage-backed securities. And if you are investing large amounts of money, Vanguard's higher trading volume could translate into lower trading costs. But Schwab has a good track record with its stock index funds, and you might prefer this fund's benchmark, the Dow Jones U.S. Broad Stock Market Index. (Vanguard announced today that its Total Stock Market Index fund and ETF shares will transition from tracking the MSCI U.S. Broad Market Index to the CRSP U.S. Total Market Index.)

Schwab's Parent rating partly stems from an SEC complaint detailing misleading statements made about the ill-fated Schwab YieldPlus, a so-called money market alternative that suffered steep losses in the financial crisis. Now headed by Marie Chandoha, Schwab's investment management operation seems to be on a straight-and-narrow path, but we are still reserving judgment. Further, Schwab funds have minimal management ownership, and that is a significant component of the Parent pillar because managers with money on the line have an incentive to excel.

Management investment is arguably less critical for index funds, though. Price, on the other hand, is key, and by that measure, Schwab fares well. Indeed,  Schwab Total Stock Market Index (SWTSX) has earned an Analyst Rating of Silver. With a 9-basis-point expense ratio and an entry-level $100 minimum investment, it is a compelling option for new investors buying their first mutual fund. Of course, shareholders burned when Fidelity jacked up expenses on some of its retail index fund shares last year might be skeptical, but Schwab's determination to compete on cost has become a defining aspect of its culture.

Actively managed funds can also rise above bad parents, particularly when they are run by subadvisors. We called  Laudus Growth Investors U.S. Large Cap Growth (LGILX) "a hidden gem" when we issued it a Bronze Analyst Rating earlier this year. The fund earns Positive scores on four of the five pillars that go into the rating--the only Negative being its parent, Schwab. Lawrence Kemp and his team of experienced analysts work for subadvisor  UBS (UBS), and they have created a terrific 10-year track record using a disciplined focused-growth strategy. Given that and relatively low expenses, the fund has a good chance of maintaining its edge.

 Dreyfus Appreciation (DGAGX) is another example of a subadvised fund that stands above its parent. A low-turnover, high-quality portfolio managed by Fayez Sarofim & Co. since 1990, the fund's strong risk-adjusted performance might attract cautious large-cap investors. Granted, Dreyfus itself has been in an awkward transition, merging and liquidating troubled funds and shifting to a subadvisory model. What's more, high costs and low manager investment remain concerns. But this fund's expenses are reasonable, and its $2,500 minimum is considerably less than the amount needed to invest with Fayez Sarofim directly or through a wrap account.

It is more difficult to overlook a Negative Parent rating, however, when an active fund manager is directly associated with a troubled parent. Marsico Capital Management, for example, may have addressed its debt troubles, but it is still hampered by extensive analyst turnover and several fund manager departures in recent years. Even safely entrenched managers can be a risky choice if they are not backed up by a solid organization:  Permanent Portfolio (PRPFX), for example, has an attractive record and unique premise, but both the fund and the company behind it are essentially a one-man show.

If you are considering a fund from a company with a Negative Parent rating, you need to assess whether that rating stems from problems that are likely to drag your investment down. It might be easier to take a pass; as a rule of thumb, a Negative Parent rating is a danger sign. But there are exceptions, as the Analyst Ratings mentioned above indicate. If you are constrained by investment minimums or platforms, or simply intrigued by a successful active strategy, it could be worth your while to dig deeper.