Splashy returns and a charismatic star manager may give a mutual fund some sparkle, but a successful long-term investment is built on more than first impressions. All investors--whether they're individuals with modest nest eggs or institutions with billions on the line--want their hard-earned capital managed thoughtfully and respectfully year in and year out.
Morningstar's Stewardship Grades for mutual funds are designed to highlight which funds are likely to be good long-term partners for investors, and a new study of the grades shows it pays to be choosy. Morningstar found that most funds earning high Stewardship Grades were successful in the subsequent years. Specifically, they were very likely to survive and provide competitive risk-adjusted returns.
To determine which funds are good caretakers of capital, Morningstar's fund analysts visit fund companies, conduct extensive interviews, and comb through regulatory filings to evaluate five areas: The corporate culture of the fund's parent company; the quality of the board of directors governing the fund; the fund manager's financial incentives; the fund's fees; and the fund company's history with regulators. Each of those five areas earns a score and a letter grade, and by combining the five areas, one arrives at the fund's overall Stewardship Grade. Morningstar issues Stewardship Grades--A, B, C, D, or F--to more than 1,000 funds and updates those grades regularly. At present, these grades are awarded in North America only, but we hope to roll these out across Europe in the not-too-distant future.
Poor Stewards, Poor Longevity
In the study out today, Morningstar looked at each of the five areas of the methodology, as well as the overall grade, to see which seemed to predict good outcomes for shareholders.
We first looked to see whether the funds graded in 2004--the year the Stewardship Grades were launched--survived to today. Funds earning top Stewardship Grades were very likely to survive--only about 1% of funds earning Stewardship Grades of A were killed off in the years that followed, while about one quarter of the D funds and one third of the F funds didn't survive. Presumably, most of the D and F funds were poor performers, as the fund industry typically doesn't kill off its top prospects.
From there, Morningstar examined how successful the funds were in the years after the Stewardship Grades were issued. We looked at the grades issued in 2004, after the initial launch, and then again in 2007, shortly after Morningstar revised its Stewardship Grade methodology. In the study, funds deemed successful were those with Morningstar Quantitative Ratings of 3 or more stars, while the unsuccessful funds, as well as funds that didn't survive, were those earning 1 or 2 stars. This definition allowed us to calculate a Morningstar Rating success ratio for funds earning a particular Stewardship Grade.
Strong Stewards, Strong Risk-Adjusted Returns
We found that the Morningstar Rating success ratios were significantly higher for funds earning As and Bs for the overall Stewardship Grade. More than 80% of the funds earning those top grades turned in competitive risk-adjusted returns relative to their peers.
Morningstar also looked at the Morningstar Rating success ratios of three components that make up the Stewardship Grades: corporate culture, board quality, and manager incentives. Of those three components, the funds earning As for corporate culture stood out. To earn an A for corporate culture, a fund must hail from a firm that consistently puts its fund investors before its own profits by offering a sensible lineup of funds at fair prices. Fund firms with strong cultures also have little personnel turnover and avoid launching trendy funds that investors tend to buy and sell at inopportune times--like buying late in a rally and selling at the depths of a decline.
The funds earning an A in corporate culture were very often successful, suggesting that shareholder-friendly practices correlate with competitive risk-adjusted performance: A whopping 87% of the funds earning As for corporate culture were successful according to the Morningstar Rating success ratio. The funds earning Bs and Cs for corporate culture weren't as successful as the As, but they were more successful than funds earning failing grades for corporate culture.
Paying for Performance
The results for the manager-incentives component also were encouraging. This portion of the methodology measures whether a fund manager's own financial incentives are aligned with fundholders'. Morningstar looks to see whether the manager invests substantially in fund shares and gets paid, through his employer's bonus compensation plan, to deliver strong long-term returns.
Our study of the manager-incentives grades found that managers who get paid to deliver strong performance--and profit from that performance through ownership in the fund--had good results. More than three quarters of the equity funds earning As for manager incentives were successful, while funds with lower manager-incentives grades were less successful. Among the fixed-income funds, so few earned As that we couldn't draw conclusions from those funds' results, but the bond funds earning Bs and Cs were also largely successful. This study's conclusions are in line with Morningstar's January study of industrywide data on manager ownership of fund shares.
The methodology area that showed less correlation with good risk-adjusted returns was the board-quality component of the Stewardship Grade. This component considers whether the fund board overseeing the fund is highly independent and has served shareholders well by negotiating low fees and overseeing a sensible lineup of funds run by skilled managers. Morningstar also looks to see whether the board's independent directors invest meaningfully in shares of the funds they're overseeing.
Morningstar found that funds earning high grades for board quality were more successful than those earning middling Cs, but the differences aren't stark. The challenge in assessing fund boards--beyond quantitative criteria like independent leadership and investment in fund shares--is that boards operate behind closed doors. It can be difficult to know whether fund boards take a pit-bull or lap-dog approach to overseeing the funds' advisor.
Parsing Funds' Price Tags
Morningstar also studied the regulatory history and fee components of the Stewardship Grade methodology. To be sure, one would not expect a fund company's history with regulators to have an impact on the funds' performance, so there Morningstar limited its study to survivorship and found that funds with poor regulatory records were unlikely to survive.
The fee study, however, was more meaningful. Here, we expanded our study beyond the 1,000 funds that receive Stewardship Grades and tested every share class of every fund in Morningstar's database. Our findings were consistent with other studies Morningstar's done on fees. Specifically, Morningstar found that cheaper funds are more likely to outperform their peers on a risk-adjusted basis.
It's worth pointing out that this study differs a bit from others Morningstar has conducted relative to category peers. The fee test for the Stewardship Grades uses larger peer groups and then sorts fund share classes by sales load types. We calculated the average Morningstar Risk-Adjusted Return (as the name implies, a return metric that punishes risky funds) for each fee peer group. Then we looked to see whether the cheaper funds were more likely to outperform than the expensive funds.
Morningstar found that the funds in the cheapest quintile--all of which would earn As for fees within the Stewardship Grades--had the best risk-adjusted returns, particularly over long-term periods. Similarly, the majority of the most-expensive funds underperformed the average Morningstar Risk-Adjusted Return. This study reinforces the notion that when it comes to mutual funds, cheaper is better. (Just last week, Morningstar launched a new Fee Level score based on the same methodology used in the fee section of the Stewardship Grades.)
Putting the Stewardship Grades to Work
The results of this Stewardship Grade study demonstrate that investing with shareholder-friendly funds can pay off for investors, but Morningstar would never suggest making an investment decision based solely on a fund's Stewardship Grade. Rather, these grades tell investors at a glance whether a fund company is operating with the fundholders' best interests in mind. If given a choice between two funds with equally strong investment teams, the one sporting a top Stewardship Grade is likely to be a strong long-term partner.
