In 2004, independent investment research company Morningstar Inc introduced a Fiduciary Grade system to complement its ratings service of mutual funds by factoring in areas of mutual fund governance and operations. The fiduciary grades have no influence on its star ratings -- they are two separate tools for appraising a mutual fund.
Investors use Morningstar Rating™ as a signpost of mutual fund performance in terms of both return and risk. These ratings are a valuable tool for objectively comparing the performances of different mutual funds.
In 2003, New York Attorney General Elliott Spitzer launched actions against some mutual fund companies for allowing their privileged clients to profit from improper activities such as
late trading. In its wake, investors realized they needed more than the past performance-based ratings to assess mutual funds.
A Morningstar Rating does not get at critical intangibles such as how seriously does the mutual fund company take its fiduciary responsibility to mutual fund shareholders? Or, how aligned are the interests of the mutual fund manager and the mutual fund company with those of the fund investor?
To address this need, Morningstar created the Fiduciary Grade which looks at the regulatory issues, board quality, manager incentives, fees and corporate culture of mutual funds. So far, the company has graded about 635 mutual funds, which includes the largest 500. It plans to eventually provide fiduciary grades for 2,000 mutual funds.
How the Mutual Funds are Graded
The Morningstar Fiduciary Grade is based on the evaluation of five areas critical for mutual fund governance and its operations. Morningstar generally assigns to mutual funds points ranging from 0 (Very Poor) to 2 (Excellent) in increments of 0.5 for each of these five areas.
The scores of each of the five areas are aggregated and the mutual fund is assigned a Fiduciary Grade based on the total number of points:
A=9-10
B=7-8.5
C=5-6.5
D=3-4.5
F=2.5 or less
1. Regulatory Issues: Morningstar examines if the mutual fund company has had any regulatory issues within the past three years. If so, what corrective actions has the mutual fund company implemented? Unlike the other four areas, the minimum score here can be a minus 2 for serious breaches of
fiduciary duties.
2. Board Quality: Morningstar looks for a demonstrated track record of the mutual fund board in protecting the interests of mutual fund investors. Mutual funds get kudos if their independent directors invest in the mutual funds.
3. Manager Incentives: This score is based on Morningstar's evaluation of mutual fund ownership and compensation structure. Mutual funds where the fund's manager owns a meaningful stake in the fund score high on the fund ownership dimension. A compensation structure that rewards the mutual fund manager for long-term mutual fund performance is favored.
4. Fees: Mutual funds are rewarded for having
expense ratios lower than that of their peers and for effectively reducing their expense ratios with asset growth.
5. Corporate Culture: Morningstar looks for tangible evidence that the mutual fund company takes its fiduciary responsibility seriously. Among the factors it considers are softer issues like whether the company closes mutual funds when they get too large and whether the company starts trendy mutual funds to garner assets.
Using the Morningstar Fiduciary Grade
1. Buy and Hold Investors: Buy and hold mutual fund investors first need to examine how mutual funds in their portfolios stack up on the two measurements -- Morningstar Rating and Fiduciary Grade.
Mutual funds that rank favorably on both dimensions may be retained and mutual funds that rank unfavorably on both dimensions may be replaced by ones that rank favorably.
For mutual funds that rank favorably in one dimension but not in the other, the answer is not so clear-cut. Retaining a fund with a strong Morningstar Rating but lower Fiduciary Grade is a matter of personal choice. Conversely, a mutual fund's Fiduciary Grade may be satisfactory but the Morningstar Rating may be unfavorable. This may just be a case of the mutual fund manager going through a temporary bad patch. Investors have to weigh these factors along with tax consequences before deciding to sell a mutual fund.
Given the number of mutual funds available, investors seeking new mutual funds to add to their portfolio should in general have no trouble in finding mutual funds with a favorable Morningstar Rating as well as Fiduciary Grade.
2. Tactical Asset Allocators: A tactical asset allocator uses an active investment strategy and typically invests in mutual funds such as sector funds. For example, AlphaProfit uses its
ValuM investment process to periodically alter the mix of its mutual fund model portfolios to take advantage of specific trends such as rising natural gas prices or the introduction of new wireless technologies.
Since
tactical asset allocators seek superior performance during their mutual fund holding period, factors such as superior long-term performance which determine a Morningstar Rating are less important to them. However, these investors typically seek to own mutual funds within a single family such as Fidelity Investments for purposes of administrative ease. As such, tactical asset allocators will find the Fiduciary Grade useful in evaluating and choosing mutual fund families to implement their strategies.
AlphaProfit's View on the Morningstar Fiduciary Grade
The Fiduciary Grade system is a blend of several metrics. The grading of mutual funds on regulatory issues is backward-looking rather than a prognosticator of potential future trouble. The grading system includes a quantitative dimension in mutual fund fees. Also included are qualitative dimensions such as mutual fund corporate culture, manager incentives and the quality of the board of directors.
The Fiduciary Grade provides mutual fund shareholders with much-needed insight into the governance and operations of mutual funds. The Morningstar Fiduciary Grade system is a good first step. AlphaProfit believes Morningstar will refine the Fiduciary Grade system over time, just as they refined their ratings system.
While Morningstar Rating does an excellent job of objectively evaluating past performance, financial markets by their very nature do not allow the investor to predict future performance based on these ratings alone. Many times, funds with a rating of four or five stars do not live up to their expectations. Some highly rated funds have in fact delivered disappointing returns.
Whether the recently introduced Fiduciary Grade will indeed prove to be a better indicator of future mutual fund performance remains to be seen. However, shares of companies with better governance practices tend to perform better, according to studies by Prof. Gompers and Prof. Ishii of Harvard University and Prof. Metrick of the University of Pennsylvania.
Investors will find the Fiduciary Grade system valuable in their mutual fund decision-making process if the Fiduciary Grade either by itself or in combination with the Morningstar Rating proves to be a better indicator of future performance. AlphaProfit believes the Morningstar Fiduciary Grade has the potential to become a worthy metric of mutual fund stewardship over time.
By Sam Subramanian, Managing Principal
AlphaProfit Investments
Sam Subramanian, PhD, MBA is Managing Principal of AlphaProfit Investments, LLC. Sam developed the ValuM™ Investment Process for managing investments. He edits the AlphaProfit Sector Investors' Newsletter™, a publication that discusses investments using Fidelity mutual funds. For the five-year period ended December 31, 2003, AlphaProfit model portfolios increased by up to 252%, a compound annual return of 28.6%. To learn more about AlphaProfit and to subscribe to the FREE newsletter, visit www.alphaprofit.com
