Good Governance Leads to Good Returns
Panelists at the Morningstar Investment Conference discuss the importance of fund stewardship and its connection to good investment results.
This analyst blog is part of our coverage of the 2015 Morningstar Investment Conference.
Ever since the mutual fund scandals of 2003-04 exposed shady doings by some fund companies, fund investors have recognized the importance of stewardship. Morningstar began assigning fund Stewardship Grades in 2004, identifying firms that put the interests of shareholders first, as opposed to profits or asset-gathering. In "Stewardship vs. Salesmanship: Does Good Governance Improve Investment Results," a panel discussion at the 2015 Morningstar Investment Conference, three experts--Bridget Hughes of Morningstar, Jeffrey Mitchell of Fidelity, and Susan Ferris Wyderko of the Mutual Fund Directors' Forum--weighed in on the importance of stewardship and its connection to good investment results.
The first question asked by moderator Laura Lutton was a fundamental one: Why does stewardship matter? Why is it important? Hughes said that it boils down to an issue of trust--for investors, because the actions of a fund company or fund board can have a significant effect on returns, and for advisors, who have a fiduciary duty to their clients and thus want to avoid the scandals and "bad headlines" that can result from lax stewardship practices.
Mitchell, who evaluated potential subadvisors for Fidelity's multimanager funds, echoed the importance of stewardship for fiduciaries, noting that Fidelity holds its subadvisors to very high standards. Wyderko emphasized the importance of fund boards, which have a fiduciary duty to the fund itself, rather than to the advisor; thus, they're required to look out for the interests of fund shareholders.
The panelists then discussed how they evaluate stewardship in practice. Mitchell said that Fidelity looks at three primary areas: the firm itself, including organizational stability and durability; the management team, including its connectivity, incentives, and communication with shareholders; and how well the team executes its mandate and does what it says it will do.
Hughes mentioned the five elements that go into Morningstar's Stewardship Grades: corporate culture, manager incentives, fees, board performance, and regulatory issues. She noted that Morningstar evaluates these elements using a combination of quantitative measures (such as average manager tenure and manager investment) and more qualitative evaluations.
Wyderko said that independent fund directors tend to look at the same types of things described by Mitchell and Hughes, with the caveat that those directors get inside information from the fund company that may not be publicly available. She noted that fund directors are always interested in fund performance and fees, wanting to understand why the fund has performed the way it has. Mitchell echoed this, remarking that Fidelity wants to understand unusually good performance as well as bad performance; blowout returns could result from outsized risks, which may or may not be in line with the fund's mandate.
Where can ordinary investors or advisors get information to evaluate a fund's stewardship on their own? Both Mitchell and Hughes mentioned the Statement of Additional Information, which, among other things, tells how much money each of the portfolio managers have invested in the fund and has detailed information about the fund board. (Information about manager ownership is also available in Morningstar Direct and related products.)
Wyderko emphasized that there's "no magic formula for a good fund board"; each fund should have a board that reflects its needs, but in general it's good for boards to include a variety of skill sets, such as corporate executives, investment experts, and lawyers. She noted that it's always good to see independent fund directors investing their own money in the funds they oversee (information that's also available in the Statement of Additional Information).
All three panelists agreed that deciding when to close a fund to new investors and keeping an eye on fund expenses are two key responsibilities of the board. Hughes noted that Morningstar considers a board's track record in these areas when assigning Stewardship Grades, though it can sometimes be hard for outsiders to tell whether the credit (or blame) should go to the board or the fund company. Mitchell said that Fidelity asks its subadvisors about capacity all the time, in addition to looking at measures such as trading volumes. Wyderko emphasized that fund companies have financial incentives to gather more assets, so fund boards represent an important check by advocating for shareholders.
Finally, the panel discussed the importance of stewardship over salesmanship, and how to evaluate which of these a fund company considers more important. Hughes explained that Morningstar pays a lot of attention to where the assets are going, and whether a firm is gathering a lot of assets in trendy areas. "If sales people are trying to steer investors into funds that are not the firm's core strength," she noted, "that can be a warning sign that they're more concerned with salesmanship than stewardship."