Morningstar now provides
Fiduciary Grades on mutual funds. How does Morningstar
determine these grades? How can mutual fund investors use
these grades to better manage their portfolios?
Mutual fund investors use Morningstar Rating™ as a sign
post of mutual fund performance. These ratings have proved
to be 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 the aftermath of these developments, investors realize
that they need more than the historical performance based
Morningstar Ratings to evaluate mutual funds. The
Morningstar Ratings do not get at critical intangibles.
How seriously does the mutual fund company take its
fiduciary responsibility to mutual fund investors? How
aligned are the interests of the mutual fund manager and
the mutual fund company with those of the mutual fund
investor?
To address this need, Morningstar has embarked on a system
called the Fiduciary Grade. Morningstar has so far graded
about 635 mutual funds, including 500 of the largest ones.
Morningstar plans to provide Fiduciary Grades for a total
of 2000 mutual funds over time.
The Morningstar Fiduciary Grade System Basics
The Morningstar Fiduciary Grade is based on the evaluation
of five areas critical for mutual fund governance and
mutual fund 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.
1. Regulatory Issues: Morningstar examines if the mutual
fund company has had any regulatory issues within the past
three years. If so, what corrective action has the mutual
fund company implemented? Unlike the other four areas, the
minimum score here can be a minus 2.
2. Board Quality: Morningstar looks for a demonstrated
track record of the mutual fund board 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 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 get too large and whether
the company starts trendy mutual funds to garner assets.
The points scored on each of the above areas are
aggregated and the 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
Fiduciary Grade.
1. Buy and Hold Investors: Buy and hold mutual fund
investors first need to examine how mutual funds held in
their portfolios stack up on the two dimensions,
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 clear-cut. Retaining a
fund with 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
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, http://www.alphaprofit.com
uses its ValuM investment process, http://www.alphaprofit.com/mutual-fund-selection.html
to periodically alter the mix of its mutual fund model
portfolios to take advantage of specific trends (e.g.
rising natural gas prices, 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 Morningstar
Ratings 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.
Our Take on the Morningstar Fiduciary Grade System
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 board quality.
The Mutual Fund Fiduciary Grade ranking provides mutual
fund investors with much needed insight on the governance
and operations 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, just as they refined the Morningstar Ratings system.
While Morningstar Ratings do 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 Morningstar Ratings of 4- or 5-star do
not live up to their expectations.
The utility of the Morningstar Fiduciary Grade will be
significantly enhanced if superior Fiduciary Grade either
by itself or in combination with the Morningstar Rating
becomes 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.
Notes: This report is for information purposes only.
Nothing herein should be construed as an offer to buy or
sell securities or to give individual investment advice.
This report does not have regard to the specific
investment objectives, financial situation, and particular
needs of any specific person who may receive this report.
The information contained in this report is obtained from
various sources believed to be accurate and is provided
without warranties of any kind. AlphaProfit Investments,
LLC does not represent that this information, including
any third party information, is accurate or complete and
it should not be relied upon as such. AlphaProfit
Investments, LLC is not responsible for any errors or
omissions herein. Opinions expressed herein reflect the
opinion of AlphaProfit Investments, LLC and are subject to
change without notice. AlphaProfit Investments, LLC
disclaims any liability for any direct or incidental loss
incurred by a pplying any of the information in this
report. Morningstar Rating™ is a trademark of
Morningstar, Inc. The third-party trademarks or service
marks appearing within this report are the property of
their respective owners. All other trademarks appearing
herein are the property of AlphaProfit Investments, LLC.
Owners and employees of AlphaProfit Investments, LLC for
their own accounts invest in the Fidelity Mutual Funds.
AlphaProfit Investments, LLC neither is associated with
nor receives any compensation from Fidelity Investments.
Past performance is neither an indication of nor a
guarantee for future results. No part of this document may
be reproduced in any manner without written permission of
AlphaProfit Investments, LLC. Copyright © 2004
AlphaProfit Investments, LLC. All rights reserved.
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About
The Author
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 5 year period ending
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 http://www.alphaprofit.com |
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