Mutual fund stewardship grades

From Bogleheads
Jump to navigation Jump to search

In 2004, Morningstar introduced stewardship grades for mutual funds and stocks as a response to the early 2003 late trading and market timing mutual fund scandals. [1] The firm revised its grading methodology in 2007. [2]

In 2004, John Bogle introduced the notion of grading mutual fund companies according to the stewardship of asset management in a keynote speech before the American Institute of Certified Public Accountants, Personal Financial Planning Conference. Bogle termed his grading metric the Stewardship Quotient. [3] . Bogle supplied an expanded version of the Stewardship Quotient in his 2012 book, Clash of the Cultures.

Stewardship grades are meant to give investors an indication of whether the interests of a management company and fund manager are aligned with those of the fund's shareholders. Stewardship grades combine both quantitative and qualitative judgements in assessing a mutual fund company's adherence to fiduciary standards.

Morningstar stewardship grades

Morningstar provides stewardship grades for mutual funds and stock companies.

Morningstar would never suggest making an investment decision solely on a fund’s Stewardship Grade. Investors first have to evaluate whether a fund’s strategy is sensible and whether its manager is capable. But from there, the Stewardship Grades can help shareholders narrow down their choices to funds that are likely to treat them like owners—not like just another dollar through the door. At a minimum, the Stewardship Grades can help identify which funds are likely to be around for a while, and if the survivors have a performance edge as well, all the better.

— Morningstar [4]

Methodology

Morningstar stewardship grades are assessed across five categories. Each component is given a range of possible points. The points are then tallied and given a lettered grade. [5]

Morningstar Mutual Fund Stewardship Grades - Components
Category Points Factors
Corporate culture 0 to +4 * Fund focus: investing (+) opposed to gathering assets. (-)
* Thoughtful, repeatable, investment process. (+)
* Straightforward communications, pertinent disclosures, responsible marketing. (+)
* Encourage long careers for talented investors. (+)
Board quality 0 to +2 * Board acts in shareholder's best interest. (+)
* Board directors have meaningful (75%) investment in funds overseen. (+)
Manager incentives 0 to +2 * Fund ownership: fund manager invests in the fund (higher investment/higher points).
* Compensation: long term performance compensation (+) vs. asset growth (-).
Fees 0 to +2 * Score assessed on quartile expense rankings; highest score for lowest cost quartiles.
Regulatory history -2 to 0 * Negative points awarded for breaches of fiduciary duty.

The composite point tallies are then ranked according to the following scale:

Morningstar Stewardship Grades [4]
Grade Points Distribution of rated funds
(03/25/11)
A 9 - 10 90
B 7 - 8.5 359
C 5 - 6.5 455
D 3 - 4.5 145
F 2.5 or fewer 2

Morningstar measures each fund's score against it peers. Morningstar categories have been combined where appropriate to form 37 comparison groups of funds that invest in similar asset types. Morningstar admits that its coverage of funds contains selection bias due to its emphasis on widely-held funds. Quoting Morningstar: "Many of the industry’s largest funds and largest fund companies got that way because they’ve been decent stewards of fundholders’ capital." [4]

In the 2011 Morningstar Global Investor Experience Study the U.S. is given an overall A rating, with an C+ rating for regulation and taxes:

U.S. global grades [6]
Category Grade
Overall grade A
Regulation and taxation C+
Disclosure A
Fees and expenses A
Sales and media A

What stewardship grades reveal

A 2011 Morningstar study of its stewardship grades [4] offers the following conclusions:

  • Funds with failing stewardship grades were very often killed off by merger or liquidation. Funds earning A’s almost always survived.
  • In the years after the grades were issued, funds earning high grades were very likely to garner Morningstar Ratings of at least 3 stars, demonstrating that on a risk-adjusted basis, the funds kept up with or surpassed peer funds with similar strategies.
  • The top-graded funds had calendar-year category and investor returns that edged past peers.

In a 2011 study, [7] Gottesman and Morey take issue with the Morningstar conclusions. Examining the corporate culture standard (the highest weighted Morningstar standard) the authors come to the following conclusions:

  • High stewardship graded firms were strongly associated with low fees, long manager tenure, low turnover, and fund survival.
  • However, high stewardship graded funds provided no consistent investment performance advantage over lower rated funds.
  • A strong corporate culture may insulate a mutual fund from scandal but will not result in the mutual fund outperforming the market.

Morningstar responded [8] to Gottesman and Morey:

  • Gottesman and Morey examine U.S. stock funds; the Morningstar stewardship grades include international funds.
  • Gottesman and Morey rank stewardship graded mutual funds in relation to Sharpe ratios; Morningstar rates the funds according to peer groups.
  • Gotteman and Morey deal with fund closures by replacing killed funds with replacement funds; Morningstar does not use replacement funds.

Morningstar stewardship grades for Canadian funds

Morningstar launched stewardship grades for Canadian funds in June 2010. The first publication of stewardship grades was marked by controversy, as Investment Funds Institute of Canada (IFIC) president and CEO Joanne De Laurentiis tried to discourage Morningstar from releasing the report by sending member firms a copy of a letter sent to Morningstar Inc. president Don Phillips. The letter expressed the following complaints:

  • Morningstar’s view is that “firms that believe in advice and deliver investment products through the advisors should be penalized.”
  • The study is qualitative and subjective.
  • The disclosure of fund manager compensation is not required by Canadian regulation.
  • Stewardship Grades have no predictive value to investors. [9]

Morningstar issued a quick rebuttal and published its report. [10]

Methodology

Morningstar's Canadian stewardship grading system is similar to that used in the U.S. market. The system includes four factors: [11]

  • Corporate Culture : maximum score is 5 points
  • Manager Incentives: maximum score is 3 points
  • Fees: maximum score is 2 points
  • Regulatory History: maximum score is 0 points, and the lowest possible score is -2 points.

The letter grading system is similar to the U.S.system:

Morningstar Canadian Stewardship Grades for Fund Firms [11] [12]
Grade Points Distribution of rated firms
(11/15/11)
A 10 - 8.75 4
B 8.5 - 6.25 7
C 6 - 3.75 13
D 3.5 - 1.25 2
F 1 or fewer 0

In the 2011 Morningstar Global Investor Experience Study Canada is given an overall C+ rating, with an F rating for fees and expenses:

Canada's global grades [6]
Category Grade
Overall grade C+
Regulation and taxation D
Disclosure B+
Fees and expenses F
Sales and media A

Morningstar Global Investor Experience Study

We hope our global study will help investment companies, distributors, and regulatory bodies worldwide continue to focus on and enhance best practices for investors.

— Morningstar

Morningstar also has initiated reports of investor experience in twenty two countries in North America, Europe, Asia, and Africa. The Global Investor Experience Study grades national markets in four categories:

  • Regulation and Taxation
  • Disclosure
  • Fees and Expenses
  • Sales and Media

The first study was issued in 2009. [13] The second study was issued in 2011. [6] The following table provides the 2011 grading on national markets:

2011 Morningstar Study [14]
Country Grade Country Grade
Singapore A Germany C+
United States A Japan C+
Thailand A- United Kingdom C+
India [15] B Australia C
Netherlands B Belgium C
Switzerland B Hong Kong C
Taiwan B Italy C
China B- Norway C
Sweden B- Spain C
Canada [16] C+ South Africa C-
France C+ New Zealand D-

Bogle stewardship quotient

I offer the highly subjective viewpoint that was the driving force in my creation, 30 years ago this coming September, of a firm that would hold stewardship as its highest principle. Even though my career has, alas, reflected those values of stewardship imperfectly, you may regard my listing of these elements as self-serving, especially since the model of a fund group with a mutual, shareholder-owned structure has yet to be emulated, or even copied. Perhaps it is. But please know that I gain no pecuniary benefit by fostering these standards, only the profound conviction that they are the right ones for fund investors, the right ones for you, and, in the long run, the right ones for the fund industry.

— John Bogle[3]

John Bogle, throughout his professional and literary careers, has stressed the need for the investment management industry to practice higher fiduciary standards. In books and papers he has been a severe critic of mutual fund business practices. Bogle has argued for the need of a legislative fiduciary standard governing the investment industry. [17] [18] Among Bogle's criticisms:

  • The investment industry imposes high costs on investors through high management costs,[19] and excessive turnover of equity investments. [20]
  • The mutual fund industry creates too many new and speculative funds, and practices short term speculation as opposed to long term investment.[19] This conduct has encouraged investors to likewise increase their turnover of fund shares. [20]
  • The mutual fund industry has moved from being predominately managed by the values of a profession to one predominately run by the values of a business. The industry has increasingly undergone a transition to conglomerate ownership of mutual fund companies, to the detriment of investment performance.[19]
  • The mutual fund industry fails to properly exercise its oversight role as owners of businesses. [19]

Methodology

John Bogle's updated Stewardship Quotient sets up 15 mutual fund standards for investor consideration. Each standard has four conditions which are graded (3 points, 2 points, one point, and zero points). The points are summed and divided by 15. This result is then multiplied by 100 to arrive at a fiduciary score. Thus, the highest grade a mutual fund company can earn is 300 points.

John Bogle: Stewardship Quotient [21]
1. Management fees and operating expense:
  • Very low (3 points)
  • Below average (2 points)
  • Average (1 point)
  • Above average (0 points)

2. Equity portfolio turnover:

  • Under 30% (3 points)
  • 30% - 50% (2 points)
  • 50% - 100% (1 point)
  • Over 100% (0 points)

3. Equity diversification:

  • Owns total market (3 points)
  • Large cap blend (2 points)
  • Other broad style (1 point)
  • Sector funds (0 points)

4. Marketing orientation:

  • Sells what it makes (3 points)
  • Gives in, but rarely (2 points)
  • Gives in sometimes (1 point)
  • Makes what will sell (0 points)

5. Advertising

  • None (3 points)
  • Limited (2 points)
  • Extensive (1 point)
  • Performance (0 points)

6. Pays for distribution:

  • No (3 points)
  • Broker dealer low pay (2 points)
  • Broker dealer high pay (1 point)
  • Supermarket shelf space (0 points)

7. Sales commissions:

  • Strictly no load (3 points)
  • No-load with small 12b-1 fee (2 points)
  • Low-load (1 point)
  • Substantial sales loads + 12b-1 fee (0 points)

8. Shareholder stability [note]:

  • Under 20% (3 points)
  • 30% - 40% (2 points)
  • 40% - 50% (1 point)
  • Over 50% (0 points)

9. Limitations on fund size:

  • Willing to limit size (3 points)
  • Closings when appropriate (2 points)
  • Rare fund closings (1 point)
  • No limits on size (0 points)

10. Experience, stability of fund managers:

  • More than 10 years (3 points)
  • 5 - 10 years (2 points)
  • Less than 5 years (1 point)
  • New manager (0 points)

11. Insider ownership of fund shares:

  • Large, and in many funds (3 points)
  • Moderate, and in many funds (2 points)
  • Moderate, but in few funds (1 point)
  • Small or none (0 points)

12. Organization of fund manager:

  • Mutual (3 points)
  • Privately owned (2 points)
  • Publicly owned (1 point)
  • Conglomerate (0 points)

13. Compensation of fund board:

  • Independent of manager (3 points)
  • Largely independent (2 points)
  • Many insiders (1 point)
  • Many links to manager (0 points)

14. Chairman of fund board:

  • Unaffiliated with adviser (3 points)
  • Separate from chief executive (2 points)
  • Official of conglomerate (1 point)
  • Head of conglomerate (0 points)

15. Regulatory infractions:

  • None or insignificant (3 points)
  • No recent major infraction (2 points)
  • Minor infraction (1 point)
  • Major infraction (0 points)
Note: Shareholder turnover is calculated by the ratio of shareholder redemption divided by average net assets (R/ANA).

References

  1. Introducing the Morningstar Stewardship Grade for Funds, Morningstar . Retrieved 27 August 2012.
  2. Morningstar grading funds on a steeper curve, John Spence (June 19, 2007), MarketWatch. Retrieved 24 August 2012.
  3. 3.0 3.1 Has Your Fund Manager Betrayed Your Trust? Consider the “Stewardship Quotient”, Bogle Financial Research Center. Retrieved 24 August 2012.
  4. 4.0 4.1 4.2 4.3 2011 Mutual Fund Stewardship Grade Research Paper, Morningstar
  5. Morningstar Stewardship Grade Methodology
  6. 6.0 6.1 6.2 Global Fund Investor Experience 2011, Morningstar
  7. Gottesman, Aron A. and Morey, Matthew R.,Mutual Fund Corporate Culture and Performance (June 1, 2011).
  8. Morningstar Challenges Study That Questions Its Ratings, WSJ April 13, 2012.
  9. Jonathan Chevreau IFIC tried to block Morningstar report on fund stewardship, Financial Post, (Jun 21, 2010)
  10. Jonathan Chevreau, Morningstar escalates war of words with IFIC over mutual fund stewardship grades, Financial Post, (Jun 29, 2010)
  11. 11.0 11.1 Morningstar Canada Stewardship Grade Methodology
  12. Morningstar Stewardship Grades, Canada
  13. Global Fund Investor Experience 2009, Morningstar
  14. Press release, Morningstar, March 11, 2011
  15. India rated B in Morningstar global investors experience study
  16. A failing grade (again) on fees, Morningstar
  17. Bogle, John C.,The Fiduciary Principle: No Man Can Serve Two Masters, Financial Analysts Journal, CFA (Fall 2009)
  18. Bogle, John C., The Clash of the Cultures, The Journal of Portfolio Management, {Spring 2011)
  19. 19.0 19.1 19.2 19.3 Bogle, John C., The Relentless Rules of Humble Arithmetic, Financial Analysts Journal, CFA ( Nov./Dec. 2005)
  20. 20.0 20.1 Bogle, John C., The Mutual Fund Industry 60 Years Later: For Better or Worse?, Financial Analysts Journal, CFA ( Jan./Feb. 2005)
  21. John Bogle, The Clash of the Cultures, Wiley (August 7, 2012).

External links

Academic papers