Morningstar Stewardship Grades for Mutual Funds

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1 Morningstar Stewardship Grades for Mutual Funds Laura Pavlenko Lutton Editorial Director, Funds Research 2005 Morningstar, Inc. All rights reserved. Overview Launched grades in August 2004 to measure whether individual mutual funds are good stewards of investors capital. Consider five areas in determining a final grade: Corporate Culture Fund Board Quality Fund Manager Compensation Fees Regulatory History We encourage customers to consider Stewardship Grades as part of their investment research process, along with other Morningstar tools Morningstar, Inc. 1

2 Corporate Culture What makes a fund company tick? What is its history, who runs the firm, what is its expertise? Do fund managers and analysts spend their careers at the firm or is there a lot of personnel turnover? Is the firm sales focused or shareholder focused? Does it launch trendy funds? Does it close funds that have grown too large? Does it communicate well with shareholders? Does it use redemption fees? Does it use soft dollars? Corporate Culture: Some Managers are Experienced and Likely to Stay Average Fund Manager Tenure and Retention Rates Average Manager Tenure for underlying holdings of target-date funds, as of (Years) Firm-wide Manager Retention Rate as of (5-Yr Avg %) American Funds Vanguard JPMorgan T. Rowe Price MFS Putnam Fidelity Oppenheimer American Century AllianceBernstein DWS Morningstar, Inc. 2

3 Corporate Culture: How do the largest 10 fund families stack up? Fund Family Fund Mergers Since 2005 Funds Launched Since 2005 Manager Retention Annualized Since 2004 Corporate Culture Grade Vanguard A American Funds A Fidelity Investments B PIMCO Funds B Franklin Templeton B T. Rowe Price A John Hancock C OppenheimerFunds C Dodge & Cox A Columbia C Board Quality Is the fund board highly independent? Independent chairmen and 75% independent directors make it more likely that the board will act independently. Do the independent directors invest in the funds they oversee? Does the board act in shareholders best interest? Negotiate for lower fees Close funds that are too big Push back on trendy fund launches Fire underperforming management teams Morningstar, Inc. 3

4 Manager Incentives Do managers get paid to deliver strong long-term performance? Do managers invest meaningfully in the funds they manage? More than $1 million in a core fund More than $100,000 in a specialty fund Manager Investment: Managers Who Invest in Funds Outperform Peers Ownership Level (SAI data as of July 2009) Average Rank Category: 5 yrs # of Funds More than $1 million Between $500,001 and $999, Between $100,001 and $500, Between $50,001 and $100, Between $10,001 and $50, Between $1 and $10, $0 54 2, Morningstar, Inc. 4

5 Fees Is the fund a good value proposition? Morningstar research shows that fees are the most important predictor of long-term fund performance Cheapest funds get As If more expensive than 60% of peers, funds earn an F. Fees: Price Matters for Domestic Equity Funds Category Expense Quintile % Surviving Past 10 Years Average Category Rank Average Std Dev Rank Cheapest Quintile Most Expensive Quintile Morningstar, Inc. 5

6 Fees: Price Matters Even More for Bond Funds Category Expense Quintile % Surviving Past 10 Years Average Category Rank Average Std Dev Rank Cheapest Quintile Most Expensive Quintile Regulatory Issues Has the fund company had run-ins with regulators, and if so, how serious were they? Were shareholders harmed? Have wrong-doers been fired? Are procedures in place to make sure problems don t occur in the future? Take points away for infractions, can move back up to zero with good behavior over time Morningstar, Inc. 6

7 Stewardship Grade Coverage Maintain coverage on more than 1,000 mutual funds Deeper coverage of big fund families Fewer smaller families Emphasis on families with Fund Analyst Picks Broadening coverage in 2010 Update grades annually or on an as-needed basis Grade Distribution: Bell curve is not intentional As Bs Cs Ds Fs Morningstar Stewardship Grades Grade Distribution As 6% Bs 24% Cs 47% Ds 20% Fs 3% 2005 Morningstar, Inc. 7

8 It s Tough to Partner with Poor Stewards Stewardship Grades for Funds % of domestic equity funds as of December 2004 killed off since December 2004 A 2% B 8% C 6% D 25% F 38% Asset Growth at Funds by Stewardship Grade Stewardship Grade A B C D F Average Asset Growth Per Fund, $181.7 M +$103.0 M +$2.2 M - $12.3 M - $8.5 M Average Asset Growth Per Fund, $839.6 M +$490.7 M +$39.6 M - $66.9 M - $20.1M 2005 Morningstar, Inc. 8

9 A Link Between Good Stewardship, Performance Researchers at Cornell and Binghamton Universities found funds receiving A or B Stewardship Grades outperformed by 1.6 percentage points relative to funds earning Ds and Fs. When we started this research, being a cynical academic, I sort of expected to find nothing of any value in these grades. But I was convinced otherwise. -- Jay Wellman, professor at Cornell University, quoted in Seeking a mutual fund you can trust? by Mark Jewell of the Associated Press, March 19, Morningstar, Inc. 9