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New Morningstar grade great for investors

Updated: May 3, 2013 12:14PM



Originally published: August 26, 2004

Americans have more than $5 trillion invested in more than 6,000 mutual funds. They’ve trusted the fund management companies and individual managers to make the best possible investment decisions for these hard-earned dollars. And in the vast majority of cases, the fund companies have acted wisely and responsibly in the interests of their fund shareholders.

But last year’s revelations that some fund companies acted irresponsibly have triggered action both from government regulators and from the bible of the mutual fund industry, Chicago-based Morningstar Inc.

Morningstar has always been the best source for in-depth analysis of mutual funds and their performances relative to their category. Morningstar’s widely followed star ratings give from one to five stars as an assessment of past performance on a risk-adjusted basis. In fact, these ratings have become a sort of de facto Good Housekeeping Seal of Approval for individual funds, although Morningstar always points out that past performance is not a guarantee of future results.

Rating the management

Now Morningstar is introducing a new comparison standard: the Morningstar Fiduciary Grade. This is an A to F grading system like the one used in school. It is based not on performance, but on fund management practices. Combined with star ratings, investors now will be able to act in a more enlightened way when it comes to making investment decisions.

The highest fiduciary grades are assigned to funds whose management companies align their interests with those of fund shareholders. The graded categories include:

* Regulatory issues. How well a fund company complies with promises to remedy previous violations.

* Board quality. While the fund management company makes its profits on fees, the directors are supposed to be acting in the interests of shareholders, who benefit from lower fees. Now, this section of the Morningstar fiduciary grade will measure whether directors are truly independent, whether they are actively involved, and whether they have “meaningful” investments in the funds they oversee. (Morningstar considers a director’s investment in fund shares to be meaningful when it exceeds his or her annual cash compensation -- which can run into the six figures at many fund complexes.)

* Manager incentives. The SEC has just created new rules that will require funds to disclose the structure of management’s compensation. That information has been highly guarded until now. But investors can make better decisions if they know how the fund manager is compensated. Some possibilities include measuring performance against a benchmark, or by growth in assets. And investors deserve to know if a fund manager has a significant portion of his or her own assets invested in the fund, as it’s arguably the most direct way to align management’s interests with those of fund shareholders.

* Fees. It didn’t matter much when the market was soaring, but now investors are noticing that high management expenses can eat into returns. Morningstar will assess expenses relative to other funds in the same category, as well as whether expenses actually decline as a fund’s assets grow -- a logical outcome that doesn’t always occur.

* Corporate culture. If you get reports and statements from only one or two fund companies, it’s hard to judge their communications. Morningstar will make those comparisons and more. Analysts will watch corporate policies on payments for research, on prudence of advertising and other subjective but important aspects of fiduciary responsibility.

No guarantees

And don’t assume that top-notch performance will translate to high marks on Morningstar’s fiduciary grading scale. Morningstar senior mutual fund analyst Jeffrey Ptak says some funds that have excellent records could have very low Fiduciary Grades based on fees and other measures of shareholder friendliness. Thus, he expects the fiduciary grade will serve as a valuable input as investors decide on mutual fund investments.

You can find these fiduciary grades at Morningstar.com if you’re enrolled as a premium member of Morningstar for $115 a year.

By using the new Morningstar Fiduciary Grade, investors will be in a better position to choose the best fund for their money. And that’s The Savage Truth.

Terry Savage is a registered investment adviser, and appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast. Distributed by Creators Syndicate.



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