Grading Governance

The mutual fund scandals have put advisors in a tough position: Recommending a fund that ends up in the headlines can deal a serious blow to an advisor's reputation and can even mean lost clients. One way to be safe is to stick with companies that have avoided running afoul of regulators so far, such as American Funds and T. Rowe Price. But focusing on a few fund families eliminates some of the top-performing

The mutual fund scandals have put advisors in a tough position: Recommending a fund that ends up in the headlines can deal a serious blow to an advisor's reputation and can even mean lost clients.

One way to be safe is to stick with companies that have avoided running afoul of regulators so far, such as American Funds and T. Rowe Price. But focusing on a few fund families eliminates some of the top-performing choices.

There is one way to have it both ways: Check one of the fund-rating services that consider governance problems. These services use a variety of criteria to rule out funds with regulatory problems and other potential bombshells.

Good Morningstar

Perhaps the most ambitious effort is a new service launched by Morningstar, known as Fiduciary Grades. The Chicago-based fund tracker awards letter grades for a fund's governance, ranging from A to F. Unlike the company's star ratings, the latest evaluations have nothing to do with historical returns. Instead, Morningstar analysts make judgments in five areas, including regulatory problems, fees and manager compensation. For each area, funds receive a grade that is accompanied by a paragraph or two of text explaining how analysts reached the conclusion.

So far the grades have received little attention. But that is starting to change. In its letter to shareholders for the third quarter of 2004, for instance, Longleaf Partners said that it was “extremely proud” to receive a top grade.

Though the evaluations are necessarily subjective, Morningstar attempts to apply some empiricism as well. A fund gets marked down when its expense ratio exceeds the average of its peers. In addition, funds are expected to lower fees as they become larger and enjoy economies of scale.

“These are not tough hurdles to meet,” says Christopher Traulsen, a Morningstar senior analyst. “If a big fund is not making any effort to lower fees, then you have to wonder whether the board is focused on protecting the interests of shareholders.”

Morningstar grades funds on how their boards work, too. A lack of independent directors causes demerits. So does a director who oversees more than 12 funds. There is nothing magic about the number 12, Traulsen concedes, but the fund tracker wanted to make the point that overseeing fewer funds is better than overseeing more.

In its grading system, Morningstar pays close attention to whether portfolio managers are investing in their own funds. A company gets reduced grades when managers fail to put at least one-third of their liquid assets into their own funds. Board members are expected to invest the equivalent of one year's pay. Many financial advisors applaud the idea of managers investing at home. “Good managers invest in their own funds,” says Kathleen Piaggesi, who heads K/A/P Planning Advisory, a registered investment advisor in Scarsdale, N.Y. “If a manager is not willing to eat his own cooking, then I am reluctant to buy that fund.”

The final overall Morningstar grades are the sum of the scores in the various areas. Funds can score high in one area, and still receive a poor overall mark. While PBHG Mid-Cap has a board that is 100 percent independent, Morningstar gave the fund an overall grade of F. The directors oversee 26 funds, a figure that is too high, Morningstar says. More critically, the board failed to prevent managers from allowing market-timing abuses that got the company in trouble with regulators. In addition, the company charged above-average fees and failed to close funds when they became too large.

What's in a Letter?

Should you avoid a fund just because it receives a C from Morningstar? Not necessarily. Some top-returning funds — including Scudder Dreman High Return and Clipper Focus — received mediocre fiduciary marks. But if a fund has weak returns and failing fiduciary grades, then it may be time to look elsewhere.

“The fiduciary grades are just one tool, but they are an important new tool,” says Louis Stanasolovich, president of Legend Financial Advisors, a registered investment advisor in Pittsburgh. “Advisors may soon feel pressure to pick funds with good grades.”

While Morningstar's system is winning applause, other fund-rating services take a different view. Standard & Poor's gives letter grades to funds based on criteria such as fees. Like Morningstar, S&P does not give top marks to any funds that run afoul of regulators. But funds can get high grades, even if their boards are not considered independent and don't invest heavily in their own funds.

“All the concern about boards is a distraction from more important issues,” says Phil Edwards, managing director of S&P's investment services. “You had companies like Putnam that had independent boards and still got into problems. On the other hand, there are top companies like Dodge & Cox that stayed out of trouble and did not have independent boards.”

For another view of governance issues, Litman/Gregory, an advisor in Orinda, Calif., provides No-Load Fund Analyst, a newsletter, and advisorintelligence.com, an online service. Litman/Gregory seeks funds where the entire corporate culture is geared toward serving shareholders. Recommended funds have no serious regulatory blemishes, low staff turnover and consistent investing styles. The newsletter aims to find funds with low fees and funds where managers close portfolios before they become bloated. Recently the newsletter lowered its grade of Artisan MidCap from highly recommended to recommended. While the newsletter remained confident that the fund could outperform its benchmark, the raters worried that the fund was attracting more assets, which could make trading more difficult and possibly lower returns in the future.

Whether or not advisors use the ratings services, they should still make some efforts to evaluate the governance of funds. One place to look is the statement of additional information provided by funds. There you can learn about who owns a fund and whether the owners have invested in the portfolio. And in this era of regulatory problems, advisors should keep a close eye on news sources such as The Wall Street Journal, says Donald Trone, chief executive of Fiduciary Analytics, a consulting firm in Sewickley, Pa. If a senior executive of one of your favorite funds has run into regulatory problems, then it may be time to sell.

“Registered investment advisors have a fiduciary duty to take news reports into consideration,” Trone says. “As soon as one of your funds lands in the news, then you must start a file showing why you have decided to keep a fund in client portfolios.”

Head of the Class

Top recipients of Morningstar's Fiduciary Grades, which rate fund governance.

Fund Ticker Fiduciary Grade 12-Month Return 3-Year Return 5-Year Return Maximum Front-End Load
American Funds Washington A AWSHX B 10.9% 6.0% 3.4% 5.75%
Davis NY A Venture NYVTX A 12.8 8.2 3.4 4.75
Oakmark I OAKMX B 11.5 7.5 7.7 0
Sound Shore SSHFX A 14.1 8.1 7.5 0
Tweedy, Browne American Value TWEBX A 8.2 5.1 3.9 0
Source: Morningstar. Returns through Oct. 31, 2004.
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