Morningstar Mutual Funds Fiduciary Grades
By Sam Subramanian, Thu Dec 8th
Morningstar now provides Fiduciary Grades on mutual funds. Howdoes Morningstar determine these grades? How can mutual fundinvestors use these grades to better manage their portfolios?Mutual fund investors use Morningstar Rating™ as a sign post ofmutual fund performance. These ratings have proved to be avaluable tool for objectively comparing the performances ofdifferent mutual funds. In 2003, New York Attorney General, Elliott Spitzer launchedactions against some mutual fund companies for allowing theirprivileged clients to profit from improper activities such aslate trading. In the aftermath of these developments, investors realize thatthey need more than the historical performance based MorningstarRatings to evaluate mutual funds. The Morningstar Ratings do notget at critical intangibles. How seriously does the mutual fundcompany take its fiduciary responsibility to mutual fundinvestors? How aligned are the interests of the mutual fundmanager and the mutual fund company with those of the mutualfund investor?
To address this need, Morningstar has embarked on a systemcalled the Fiduciary Grade. Morningstar has so far graded about635 mutual funds, including 500 of the largest ones. Morningstarplans to provide Fiduciary Grades for a total of 2000 mutualfunds over time. The Morningstar Fiduciary Grade System Basics The Morningstar Fiduciary Grade is based on the evaluation offive areas critical for mutual fund governance and mutual fundoperations. Morningstar generally assigns to pointsranging from 0 (Very Poor) to 2 (Excellent) in increments of 0.5for each of these five areas. 1. Regulatory Issues: Morningstar examines if the mutual fundcompany has had any regulatory issues within the past threeyears. If so, what corrective actions has the mutual fundcompany implemented? Unlike the other four areas, the minimumscore here can be a minus 2. 2. Board Quality: Morningstar looks for a demonstrated trackrecord of the mutual fund board protecting the interests ofmutual fund investors. get kudos if theirindependent directors invest in the mutual funds. 3. Manager Incentives: This score is based on Morningstar’sevaluation of mutual fund ownership and compensation structure.Mutual funds where the fund’s manager owns a meaningful stake inthe fund score high on the fund ownership dimension. Acompensation structure that rewards the mutual fund manager forlong-term mutual fund performance is favored. 4. Fees: are rewarded for having expense ratioslower than that of their peers and for effectively reducingtheir expense ratios with growth in their assets. 5. Corporate Culture: Morningstar looks for tangible evidencethat the mutual fund company takes its fiduciary responsibilityseriously. Among the factors Morningstar considers are softerissues like whether the company closes when theyget too large and whether the company starts trendy mutual fundsto garner assets. The points scored on each of the above areas are aggregated andthe Fiduciary Grade is assigned based on the total: A=9-10,B=7-8.5, C=5-6.5, D=3-4.5, F=2.5 or less. How Investors Can Use the Morningstar Fiduciary Grade Here are some ways investors can use the Morningstar FiduciaryGrade. 1. Buy and Hold Investors: Buy and hold mutual fund investorsfirst need to examine how held in their portfoliosstack up on the two dimensions, Morningstar Rating and FiduciaryGrade. Mutual funds that rank favorably on both dimensions may beretained and that rank unfavorably on bothdimensions may be replaced by ones that rank favorably. For that rank favorably in one dimension but not inthe other, the answer is not clear-cut. Retaining a fund withstrong Morningstar Rating but lower Fiduciary Grade is a matterof personal choice. Conversely, a mutual fund’s Fiduciary Grademay be satisfactory but the Morningstar Rating may beunfavorable. This may just be a case of the mutual fund managergoing through a temporary bad patch. Investors have to weighthese factors along with tax consequences before deciding tosell a mutual fund. Given the number of available, investors seekingnew to add to their portfolio should in generalhave no trouble in finding with favorableMorningstar Rating as well as Fiduciary Grade. 2. Tactical Asset Allocators: A tactical asset allocator uses anactive investment strategy and typically invests in mutual fundssuch as sector funds. For example, AlphaProfit uses its ValuMinvestment process,http://www.alphaprofit.com/mutual-fund-selection.html toperiodically alter the mix of its mutual fund model portfoliosto take advantage of specific trends (e.g. rising natural gasprices, introduction of new wireless technologies). Since tactical asset allocators seek superior performance duringtheir mutual fund holding period, factors such as superiorlong-term performance which determine Morningstar Ratings areless important to them. However, these investors typically
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seekto own within a single family such as FidelityInvestments for purposes of administrative ease. As such,tactical asset allocators will find the Fiduciary Grade usefulin evaluating and choosing mutual fund families to implementtheir strategies. Our Take on the Morningstar Fiduciary Grade System The Fiduciary Grade system is a blend of several metrics. Thegrading of on regulatory issues is backward lookingrather than a prognosticator of potential future trouble. Thegrading system includes a quantitative dimension in mutual fundfees. Also included are qualitative dimensions such as mutualfund corporate culture, manager incentives, and board quality. The Mutual Fund Fiduciary Grade ranking provides mutual fundinvestors with much needed insight on the governance andoperations of mutual funds. The Morningstar Fiduciary GradeSystem is a good first step. We believe Morningstar will refinethe Mutual Fund Fiduciary Grade system over time, just as theyrefined the Morningstar Ratings system. While Morningstar Ratings do an excellent job of objectivelyevaluating past performance, financial markets by their verynature do not allow the investor to predict future performancebased on these ratings alone. Many times, funds with MorningstarRatings of 4- or 5-star do not live up to their expectations. The utility of the Morningstar Fiduciary Grade will besignificantly enhanced if superior Fiduciary Grade either byitself or in combination with the Morningstar Rating becomes abetter indicator of superior future performance. We believe theMorningstar Fiduciary Grade has the potential to become a worthymetric of mutual fund stewardship over time. Notes: This report is for information purposes only. Nothingherein should be construed as an offer to buy or sell securitiesor to give individual investment advice. This report does nothave regard to the specific investment objectives, financialsituation, and particular needs of any specific person who mayreceive this report. The information contained in this report isobtained from various sources believed to be accurate and isprovided without warranties of any kind. AlphaProfitInvestments, LLC does not represent that this information,including any third party information, is accurate or completeand it should not be relied upon as such. AlphaProfitInvestments, LLC is not responsible for any errors or omissionsherein. Opinions expressed herein reflect the opinion ofAlphaProfit Investments, LLC and are subject to change withoutnotice. AlphaProfit Investments, LLC disclaims any liability forany direct or incidental loss incurred by applying any of theinformation in this report. Morningstar Rating™ is a trademarkof Morningstar, Inc. The third-party trademarks or service marksappearing within this report are the property of theirrespective owners. All other trademarks appearing herein are theproperty of AlphaProfit Investments, LLC. Owners and employeesof AlphaProfit Investments, LLC for their own accounts invest inthe Fidelity Mutual Funds. AlphaProfit Investments, LLC neitheris associated with nor receives any compensation from FidelityInvestments. Past performance is neither an indication of nor aguarantee for future results. No part of this document may bereproduced in any manner without written permission ofAlphaProfit Investments, LLC. Copyright © 2004 AlphaProfitInvestments, LLC. All rights reserved. About the author:Sam Subramanian, PhD, MBA is Managing Principal of AlphaProfitInvestments, LLC. http://www.alphaprofit.com He edits theAlphaProfit Sector Investors' Newsletter™. For the 5 year periodending December 31, 2003, AlphaProfit model portfolios increasedby up to 252%, a compound annual return of 28.6%. To learn moreabout AlphaProfit and to subscribe to the FREE newsletter, visithttp://www.alphaprofit.com |
