In 2003, New York Attorney General Elliott Spitzer launched actions against some mutual funds to make their eligible customers to take advantage of inappropriate activities such as late trading.
In the wake of these developments, investors realize that they need more than the historical performance based Mornin
gstar Ratings to evaluate mutual funds. The Morningstar Ratings do not get at critical intangibles. How seriously does the mutual fund company take its fiduciary responsibilities to the mutual fund investors? How are adjusted for the benefit of the mutual fund manager and the mutual fund company with them in the mutual fund investor?
To meet this need, Morningstar has started a system called the Fiduciary Grade. Morningstar has so far ordered about 635 mutual funds, including 500 of the largest. Morningstar plans to deliver Directorships grades for a total of 2000 mutual funds over time.
The Morningstar Fiduciary Grade System Basics
The Morningstar Fiduciary degree is based on an evaluation of five areas critical for mutual fund governance and mutual fund operations. Morningstar generally attach to mutual funds points from 0 (very bad) to 2 (excellent) at intervals of 0.5 for each of these five areas.
1. Legislative issues: Morningstar examines whether the mutual fund company has had any regulatory issues within the last three years. If so, what corrective actions are implemented the mutual fund company? Unlike the other four areas, here the minimum score may be a minus 2nd
2. Board Quality: Morningstar looks a certain performance of the mutual fund board protecting the interests of mutual fund investors. Mutual funds get kudos if their independent directors invest in unit trusts.
3. Manager Incentives: This score is based on Morningstar's evaluation of mutual fund ownership and compensation structure. Mutual funds where the fund manager owns a meaningful stake in the fund to score high on the fund ownership dimension. A compensation structure that rewards the mutual fund manager for long-term mutual fund performance is preferred.
4. Fees: Mutual funds are rewarded for having expense ratio lower than their peers and for effectively reducing their expense compared with a growth in their assets.
5. Corporate Culture: Morningstar looks for tangible evidence that the mutual fund company takes its fiduciary responsibility seriously. Among the factors Morningstar considers are softer issues like whether the company closes mutual funds when they become too large and whether it begins trendy mutual funds Garner assets.
The points scored in each of the above areas are aggregated and the Fiduciary class is allocated on the basis of the total: A = 9-10, B = 7-8,5, 5-6,5 C = D = 3-4 , 5, F = 2.5 or less.
How Investors can use the Morningstar Fiduciary Grade
Here are a few ways investors can use the Morningstar Fiduciary Grade.
1. Buy and Hold Investors: Buy and hold mutual fund investors need to first examine how mutual funds held in their portfolios stack up on the two dimensions, Morningstar Rating and Directorships Grade.
Mutual funds that can be favorably positioned on both dimensions to be retained, and mutual funds rank disadvantage on both dimensions may be replaced by those who are favorably positioned.
To mutual funds that rank favorably in one dimension but not in others, the answer is not clear. The preservation of a fund with strong Morningstar Rating but lower Directorships degree is a question of personal choice. Conversely, a mutual fund's Directorships Grade satisfactory, but the Morningstar Rating may be unfavorable. It may just be a case of the mutual fund manager going through a temporary bad patch. Investors have to weigh these factors along with the tax consequences before they decide to sell a mutual fund.
Given the number of mutual funds available, investors seeking new mutual funds can add to their portfolio, should generally have no trouble in finding mutual funds with favorable Morningstar Rating and Directorships Grade.
2. Tactical Asset Allocator: A tactical asset allocator uses an active investment strategy and typically invests in investment funds such as sector funds. For example, using Alpha Profit ValuM its investment process to periodically change the composition of its mutual fund model portfolios to take advantage of specific trends (eg rising natural gas prices, introduction of new wireless technologies).
Since tactical asset allocator seek a better performance during their mutual fund holding period, factors such as superior long-term performance, which is crucial Morningstar Ratings are less important to them. But these investors typically seek to own mutual funds within a single family such as Fidelity Investments for purposes of administrative hassle. As such, tactical asset allocator find Fiduciary Grade useful in evaluating and choosing mutual fund families to implement their strategies.
Our Take on the Morningstar Fiduciary Grade system
The Fiduciary Grade system is a mixture of several measurements. The grading of mutual funds on regulatory issues is backward looking rather than a prognosticator of potential future problems. The grading system includes a quantitative dimension in mutual fund fees. This includes qualitative dimensions such as mutual fund corporate culture, manager incentives, and board quality.
The mutual fund Directorships Grade placement gives mutual fund investors with much needed insight into the management and operation of mutual funds. The Morningstar Fiduciary Grade System is a good first step. We believe Morningstar will refine the Mutual Fund Fiduciary Grade system over time, and they refined the Morningstar Ratings system.
While Morningstar Ratings do an excellent job of objectively evaluating past performance, it makes financial markets inherently not possible for the investor to predict future performance based on those reviews alone. Many times, funds with Morningstar Ratings of 4 - or 5-star does not live up to their expectations.
Utility of the Morningstar Fiduciary degree will be significantly enhanced if superior Directorships Grade either alone or in combination with the Morningstar Rating is a better indicator of superior future performance. We believe the Morningstar Fiduciary Grade has the potential to become a worthy metric of mutual fund stewardship over time.
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