Mutual fund investors use Morningstar Rating™ as a sign post of mutual fund performance. Morningstar 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 Mutual Funds 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 actions 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 Mutual Funds 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.
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