Stewardship Grade for Fund Firms Methodology

Transcription

1 Stewardship Grade for Fund Firms Methodology Morningstar Methodology Paper April 15, Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. Reproduction or transcription by any means, in whole or in part, without the prior written consent of Morningstar, Inc., is prohibited.

2 Contents Introduction 3 Stewardship Grade Components Corporate Culture Manager Incentives Fees Regulatory History Overall Grade Analyst Commentary 8 2

3 Introduction Launched in the United States in 2004 and in Canada in 2010, the Morningstar Stewardship Grade for Canadian Mutual Fund Firms measures how closely mutual fund firms have aligned their interests with those of unitholders. Where the interests of firms and unitholders conflict, the Stewardship Grade evaluates the extent to which the interests of the latter prevail. The grade indicates whether a fund firm is likely to be a good caretaker of unitholders' capital over the long term. The Stewardship Grade is based on a simple premise: Strong stewards are more likely to provide unitholders a good experience than those who aren't. Stewardship Grades aren't meant to be viewed in isolation. Combined with an analysis of funds' management, strategy, and performance, they help investors distinguish between great investments and ones to avoid. Morningstar fund analysts draw upon a mix of quantitative and qualitative data to assess firms' regard for unitholders. Analysts grade each fund family using the same process, which assesses firms' culture, compensation and co-investment practices, fees, and regulatory history. 3

4 Stewardship Grade Components The Stewardship Grade methodology considers components that when combined intend to forecast whether a fund firm is a likely to be a good caretaker of investors' capital over the long term. Corporate Culture Manager Incentives Fees Regulatory History Board Quality (U.S. fund firms only) Morningstar analysts evaluate and assign grades from A (the best grade) to F (the worst grade) to each of these areas, and combine the component grades to arrive at an overall Stewardship Grade for a family of funds. A local committee of Morningstar fund analysts, which actively studies industry stewardship practices in its market and beyond, reviews the grades to ensure that the methodology is fairly and consistently implemented. Corporate Culture Morningstar analysts also consider how fund firms stack up on various quantitative factors, such as fund manager tenure and turnover, fund performance, fund expenses, and fund launches, mergers, and closings. This analysis helps put fund companies' practices into context. This component assesses the extent a fund firm's culture advances unitholders' best interests. A wide range of factors that put the interests of fund shareholders first is more likely to deliver good outcomes for shareholders. A 2011 study of Morningstar's Stewardship Grades for U.S. funds showed that funds offered by firms with strong corporate cultures delivered better results for their shareholders, as measured by risk-adjusted and cash-weighted investor returns. This data underscores how important a firm's culture is to its success. To determine the extent to which a firm's corporate culture is fundholder-focused, Morningstar analysts consider the following: Is the fund company focused on investment excellence or gathering assets? Do top leadership and investment professionals share common values, vision, and a clearly articulated understanding of what gives them an investment edge? Can the fund company attract and retain talent? Does the fund company foster thoughtful, repeatable investment processes? Does the fund company's product lineup reflect its investment expertise? 4

5 How well does the fund company manage capacity, and when necessary, does it close mandates to new investments? Is the fund company straightforward with investors through clear, pertinent disclosure and responsible marketing? Are the firm's funds a good value proposition overall? To answer these questions, Morningstar's fund analysts typically interview a variety of fund company personnel, including analysts, portfolio managers, chief investment officers, distribution chiefs, compliance personnel and top executives. These meetings help the analysts understand the fund firm's past successes and failures, as well as its priorities for the future. Scoring: Firms that exhibit the industry's most investor-focused corporate cultures earn full credit, or an A grade, for this component. Those that exceed the industry standard but do not demonstrate all of the industry's best practices earn Bs. Firms with standard corporate cultures earn Cs, while those trailing the industry norms earn Ds or Fs. Those letter grades translate into the following points toward a fund firm's overall grade: A = 5.00 B = 3.75 C = 2.50 D = 1.25 F = 0.00 Manager Incentives To determine whether a fund manager's own financial interests are aligned with unitholders', Morningstar primarily considers whether the funds' managers invest in fund shares alongside shareholders. In addition, Morningstar analyzes the fund manager's compensation plan to determine if it rewards strong long-term performance. Pay plans that exhibit industry best practices may boost the grade of a firm with less-than-stellar manager ownership of fund shares, while pay plans containing factors that could work against shareholders' best interests could move the overall Manager Incentives grade lower. Manager Ownership of Fund Shares Fund managers who invest in the funds they run demonstrate conviction in their investment process and align their own financial interests with fund shareholders'. Using data gleaned from fund company survey results, Morningstar analyzes fund-share ownership trends to determine whether a firm's managers meet the industry's highest standards. To gauge the level of co-investment, Morningstar asks fund companies to compare the size of managers' investments to their annual salaries on a firmwide basis. Firms with at least half of its managers investing more than two years' salary across their fund lineup represent an industry best practice. Compensation Structure Morningstar analysts use information surveyed from fund companies to determine whether fund managers' compensation plans reward long-term performance or emphasize asset growth. 5

6 Incentive programs encouraging a short-term focus (periods less than four years) or asset growth are viewed less favorably. By contrast, compensation plans assessing performance on both a risk-adjusted and after-fee basis are seen as an industry best practice. For fund firms using more than one compensation plan, Morningstar analysts will consider the plans collectively and determine the extent to which the plans reward managers who generate strong long-term performance. Scoring: Firms that exhibit an industry-leading level of co-investment at least 50% of managers hold more than two years' salary in their firm's funds generally receive an A grade for this component. Those with above average levels of co-investment at least 75% of managers hold more than a year's salary in their firm's funds typically earn Bs. Firms with standard levels of co-investment earn Cs (between 25%-75% of managers investing a year's salary), while those trailing industry norms or those who fail to disclose manager co-investment receive Ds. In addition to earning credit for high absolute levels of co-investment, firms may also receive credit for having policies that require or encourage managers to invest in their own funds. Morningstar analysts may raise a fund firm's score and letter grade if the firm's manager compensation plan which it describes in the Morningstar survey exceeds the industry standard of aligning the manager's own financial incentives with those of shareholders. Similarly, fund firms with pay plans that fall short of the industry standard may have their Manager Incentives grade lowered. Firms that don't provide co-investment and bonus compensation data receive Fs. The final letter grades correspond with these points toward the fund firm's overall Stewardship Grade: A = 3.00 B = 2.25 C = 1.50 D = 0.75 F = 0.00 Fees This section assesses whether the fund firm's offerings provide good value to unitholders. Morningstar's analysis is based on a comparison of the firm's fund fees relative to those with similar strategies and distribution models (direct to investor, advisor-only, institutional, and high net worth). It considers funds' costs on both an asset-weighted and equal-weighted basis. The latter better depicts the typical unitholder's experience, while the former measures whether a fund company generally offers unitholders a good value proposition. To smooth out year-to-year fluctuations, the analysis calculates fee data over a three year period, ranking firms' fees by quintile. Firms with low-cost funds earn the highest Fees grades. 6

7 The Fees grade may be lowered in cases where firms adopt unitholder-unfriendly fee structures, such as performance-based management fees that reward outperformance while not penalizing underperformance. Scoring: Fund firms with the most-competitive fees (generally speaking, those placing in the cheapest quintile of their comparison group) earn an A; those with fees below the industry norm (generally, the second quintile) earn Bs; those with standard fees (landing in the middle quintile) earn Cs; those with fees commonly exceeding the industry standard (the second most expensive quintile) earn Ds; and those with the industry's most-expensive funds (the priciest quintile) earn Fs. The final letter grades correspond with these points toward the fund firm's overall Stewardship Grade: A = 2.0 B = 1.5 C = 1.0 D = 0.5 F = 0.0 Regulatory History Morningstar examines any regulatory problems at the fund company in recent years. Fund firms do not earn points toward their total Stewardship Grade for this section because it is Morningstar's belief that complying with local industry regulations is a minimum expectation not a best practice. As such, serious breaches of fiduciary duty can result in a deduction of points toward a family's overall Stewardship Grade score. In the event of any breaches, Morningstar will review the remedies in place along with the scope of, and commitment to, reform. Scoring: The maximum score for the Regulatory History grade will be zero, but up to 2 points may be deducted from the fund firm's overall Stewardship Grade for those with serious regulatory violations. Scores may be raised back to zero over time as firms demonstrate better compliance controls. This section of the methodology will not carry a letter grade. Firms that have been compliant will earn Neutral ratings; those with points deducted will earn Negative ratings. Overall Stewardship Grade Morningstar arrives at a firm's overall Stewardship Grade by combining the points earned in each of the four methodology components. The following points correspond with each letter grade: A = to 8.75 B = 8.50 to 6.25 C = 6.00 to 3.75 D = 3.50 to 1.25 F = <

8 Analyst Commentary Morningstar's stewardship grading process is designed to facilitate rigor and consistency. Stewardship Ratings Committee While a single analyst is primarily responsible for each firm s Stewardship Grade, a committee made up of the Morningstar fund analyst team reviews analysts' grades to ensure that the methodology is fairly and consistently implemented. The committee actively studies industry stewardship practices in its market and beyond. It taps into Morningstar's global analyst team to ensure global asset managers are rated fairly and consistently across markets. The committee also challenges analysts' conclusions. Because committees can be susceptible to group think, analysts are assigned a "devil's advocate" for each Stewardship Grade. The "devil's advocate" is tasked with taking a contrary view of a firm's stewardship than the analyst, which helps ensure alternative views are heard. Stewardship Grades and Other Morningstar Fund Ratings The methodology for the Stewardship Grade is completely different from the Morningstar Rating for funds (the star rating ), and a fund family's Stewardship Grade has no impact on its funds' star ratings. The Morningstar Rating is a quantitative assessment of a fund's past performance both return and risk as measured from 1 to 5 stars. The Stewardship Grade is determined using some quantitative measures, but it is primarily based on Morningstar's qualitative analysis of a fund family's stewardship of unitholders' capital. The grades inform the Morningstar Analyst Rating for mutual funds, a comprehensive, forwardlooking rating launched in the fall of Stewardship Grades determine the Parent rating for all funds in the family. (Parent is one of five pillars that Morningstar analysts consider when determining an Analyst Rating for an individual fund. The remaining pillars are Process, Performance, Price, and People.) Funds from firms earning A and B Stewardship Grades will have Parent ratings of Positive; those earning C Stewardship Grades will have Parent ratings of Neutral; and funds from firms earning D and F Stewardship Grades will have Parent ratings of Negative. 8