Is Your Company a Good Steward?

Question: I generally don't pay much attention to the Stewardship ratings Morningstar assigns to funds and stocks because I care more about performance. Am I missing something?

Answer: Admittedly, stewardship probably isn't the first thing most investors consider when sizing up a fund or a stock on Morningstar.com, but those who ignore stewardship may be taking on risks they hadn't bargained for.

Morningstar's stewardship scores for fund families and companies are designed to give investors a sense of whether those in control of their investments are worthy of their trust and can be expected to act in shareholders' best interests. Think of these scores as a Better Business Bureau rating for funds and stocks. Just as you'd probably hesitate to do business with a company that hasn't always shot straight with its customers, you'd likely think twice before investing your money--far more of it than you'd probably spend at most businesses, in fact--without first making sure it'll be in good hands. That's where our stewardship assessments come in.

Grading a Fund by Its Parent
Let's start by looking at fund stewardship, which is encompassed by the Parent Pillar component of Morningstar's forward-looking Analyst Rating for Funds. The Parent Pillar methodology is based on the same criteria used in the Morningstar Stewardship Grades, which Morningstar began issuing in 2004 and are available on the 20 largest U.S. fund companies.

The methodology considers factors such as manager turnover at the firm, the investment culture, SEC sanctions, fee levels, manager ownership of the funds, and the fundholder-friendliness of the fund board. Our analysts draw on conversations with fund company leaders and a wealth of proprietary firm-level data such as firms' average manager tenure, manager retention rates, manager investment levels, average fee levels, and success ratios (the percentage of a firm's funds that survive and outperform their average category rivals).

Firms that score well in these areas get Positive Parent Pillar scores (or a Stewardship Grade of A or B); those operating at the industry standard get Neutral (or a Stewardship Grade of C); and those with serious care-of-capital shortfalls get Negative ratings (or Stewardship Grades of D or F).

Premium Members can read about why a fund's parent has received its score under the Stewardship tab of a fund data report or the Parent section of a fund's Analyst Report on Morningstar.com. 

Different Criteria for Stock Stewardship
Stewardship Ratings for stocks use a different approach than those for funds. After all, a fund company serves a very different role for its shareholders than does a corporation. In the case of the former, good stewardship is typically defined as providing fundholders the service of investing their money in a trustworthy, reliable manner while charging reasonable fees. For corporations the goal of delivering for shareholders is accomplished differently: by running their businesses effectively and profitably. (That's not to suggest that most fund companies aren't in it for the money--they are, of course--but their investor customers are not concerned with the size of their fund company's profits the way they are in the profits of companies whose stock they own.)

The Morningstar Stewardship Rating for stocks, the methodology of which is explained here, looks at a variety of factors, with a particular emphasis on a company's capital-allocation decisions. This recognizes the fact that most shareholders want to know that the companies they own are using capital wisely and attempting to build or focus their businesses to gain or preserve competitive advantages. This analysis includes looking at the price a company pays to acquire another or for other investments, the company's debt load, how the business is run and who is on its management team, and, in extreme cases, whether its executives are egregiously overpaid. Another key area of consideration is the company's dividend and share-buyback policies, because these have a direct impact on shareholders.

Companies are assigned a Stewardship Rating of Exemplary, Standard, or Poor. The majority fall into the second category, with only unusually positive or negative stewardship characteristics warranting other ratings. For example,  BP (BP) has earned a Stewardship Rating of Poor due to its spotty safety record in recent years--most notably the heavy costs incurred by the company as a result of the 2010 Gulf of Mexico oil spill. At the other extreme is oil giant and BP rival  ExxonMobil (XOM), which earns an Exemplary Stewardship Rating for its record of generating shareholder returns. 

For shareholders of these two oil giants, stewardship has likely counted for more than just brownie points. Over the past three years (through Jan. 3) Exxon has returned 12.5% per year for its shareholders, while BP has returned 6%.

When Stewardship Duties Collide
For fund companies that manage assets and that are publicly traded themselves, serving their customers (investors who own their funds) while also serving shareholders (investors who own stock in the company) can be a tricky business.

One example of a fund company that has walked this fine line well is  T. Rowe Price Group (TROW), which receives an Exemplary Stewardship Rating from Morningstar stock analysts for its management structure (the company is run by a committee of top officers), relatively low debt levels, and prudent capital-allocation decisions. T. Rowe also receives a Positive Parent Pillar score from Morningstar fund analysts for its fund management continuity, sensible fund closures, reasonable fees, and risk-conscious investment process.

In contrast,  Janus Capital Group , which has struggled with CEO and manager turnover and corporate governance issues in recent years, carries a stock Stewardship Rating of Poor and a fund Parent Pillar score of Neutral. (The Parent Pillar score is similarly hurt by manager turnover but helped by fairly attractive fees and heavy manager investment in their funds.)

Vanguard founder John C. Bogle speaks to Morningstar's Christine Benz about the conflicts of interest faced by many fund companies in this video.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.