From the November 2006 issue of Research Magazine • Subscribe!

November 1, 2006

Mutual Funds You Can Trust

In case you haven't noticed, Morningstar has been characterizing the mutual funds you research on its pages (or through its electronic services) as to their "stewardship," that is, how seriously those funds' managers take their responsibility to manage your clients' assets.

It took the widespread mutual fund scandals of 2003 to spawn this new service -- or maybe Morningstar, being the progressive company that it is, would have conceived them anyway. In any event, the rankings add a new and valuable dimension to mutual fund analysis that advisors need to pay attention to. Remember the fancy footwork you did in 2003 explaining to clients why their money was invested with firms like Janus and Strong? You should never have to repeat that experience if you follow the "stewardship rankings" of the funds you research for inclusion in client portfolios.

In the edition of the stewardship rankings prepared as of August 29, 2006 specifically for Research magazine, Morningstar's top ten best and worst mutual fund families emerged as follows:

How are these rankings derived? Explains Laura Lutton, senior mutual fund analyst with Morningstar: "We study five components in determining our stewardship scores -- regulatory issues, board quality, manager incentives, fees and corporate culture. Each component is worth a maximum of two points with an overall score of 10 possible points. With the exception of regulatory issues, the minimum score a fund can receive in each component is zero; for regulatory issues, the lowest possible score is -2."

Morningstar's scores correspond to one of the following qualitative terms: Excellent = 2 points; Good = 1.5 points; Fair = 1 point; Poor = 0.5 points; Very Poor = 0 points or fewer. "Each fund is assigned a letter grade from A to F," adds Lutton. "All funds are graded on an absolute basis. There is no 'curve.'" In short, says Lutton, the stewardship rankings try to predict whether a mutual fund is going to be a good fiduciary for its shareholders, acting with their long term interests in mind.

By digging into Morningstar's intent behind each of the five components, one comes to understand how compelling these scores are in highlighting a fund family's adherence to fiduciary principles. By "regulatory issues," Morningstar means a fund's ability, first and foremost, to stay out of trouble with regulators. Says Lutton: "We check public documents going back three years to see if a fund family has run into trouble with the SEC or Eliot Spitzer or others. If past transgressions have been serious, we look to see what these firms have done to address them in order to determine the likelihood of their having regulatory problems in the future."

Morningstar determines board quality via several variables, such as whether the chairman and board members are independent (even though not required to be by the SEC), whether the directors are investing in the funds they oversee, and whether directors have ready access to their fund managers. "Ideally, board members have invested in the funds they oversee at least the amount of their annual board compensation," says Lutton. "In other words, are their interests aligned with those of long-term shareholders?" Morningstar also considers each board's workload. "How many funds are they overseeing and is that realistic? A dozen might be too many funds for one board to keep track of."

As for manager incentives, the SEC now requires fund companies to disclose to shareholders their compensation structures, enabling Morningstar to glean this information from public disclosures. "Managers should be paid based upon how funds perform, not based on how many assets they collect," says Lutton. The classic example is a small-cap fund that should remain small to maintain performance, but incents its manager to grow the fund -- to the detriment of existing shareholders.

"We also like to see fund managers investing in their funds," adds Lutton -- ideally $1 million per investment style. In other words, if a manager is responsible for three different large-cap funds, he would have at least $1 million spread across all three. "Since we've launched this project, managers at some funds -- for example, Janus and MFS -- have increased their investments to earn their funds better grades. So managers are paying attention to these scores."

In assessing a fund's fee structure, Morningstar's main concern is that investors are charged a fair price to invest in the fund, something they determine by comparing fees among all funds and also studying fee trends for a fund that has grown. "A fund gets credit for lowering its expense ratio as it grows. We like to see the fund pass on economies of scale to shareholders."

The final component of the stewardship rankings --- the fund's corporate culture -- is perhaps the most subjective to assess, says Lutton, and is based largely on Morningstar analysts' knowledge of the fund and how it treats shareholders. What are its shareholder communications like? Does it do a good job explaining its investments and what's driving performance? And does it admit its mistakes ("We shouldn't have bought XYZ, as it was a drag on performance").

Another aspect of corporate culture is personnel turnover, says Lutton. "Is this a fund at which people like to work or does the fund have trouble keeping managers?"

Shareholder-Friendly Funds

Morningstar currently reviews about 1,200 funds to assemble its rankings -- a number that continues to grow. And from that group have emerged its list of the top ten funds. Interestingly, these families' superior rankings often reflect -- above all else -- managements' long-held beliefs in the need to "do the right thing" by shareholders.

"I don't think we've ever made a conscious decision about stewardship criteria," says Christopher Davis, manager of the Davis NY Venture and Selected American Shares funds. (The Davis Funds earned the top spot in the Morningstar rankings along with Selected, which has been managed by Davis Advisors since May 1993.) "We think about whether we're delivering value to investors."

Perhaps not coincidentally, Larry Pitkowsky, portfolio manager and part of the management team for the Fairholme Fund (6th in the rankings), echoes Davis' words: "We simply ask, 'How would we like to be treated if the roles [between investor and manager] were reversed?" Or, taking it a step further, they also ask, "How would we feel about having all of our [endeavors] on the front page of the local paper for everyone to read?" If you stick to a handful of principles like that, claims Pitkowsky, you'll tend to shake out well in these rankings.

Bill D'Alonzo, chief executive officer and chief investment officer of the Brandywine Funds (4th in the rankings), also emphasizes the importance of corporate culture, from which he says all of the fund family's operational practices stem: "Everyone at Friess Associates [manager of the Brandywine funds] recognizes that our primary obligation is to prudently grow the assets entrusted to us. Our firm is structured to maximize service to clients and shareholders through an environment that stresses respect for each other and cooperation toward achieving our common goal." That respect is one reason why they take a team management approach. "Doing so enables Friess employees to balance their work and personal lives," says D'Alonzo.

Also common among these top performers is the right attitude toward manager incentives. Says Pitkowsky: "All of our investable dollars besides cash and houses are invested alongside those of our shareholders in the fund. Fairholme officers and directors have an aggregate of $10 million invested, so we believe having your money where your mouth is is the ultimate test that should be met."

Friess Associates' numbers are no less impressive. Total investments in Brandywine funds by all fund employees equal approximately $150 million, according to D'Alonzo. In fact, he adds, "The Brandywine Funds are the only equity options in our firm's retirement plan. All of my personal stock market investments are divided among the three Brandywine Funds, the Friess Small Cap Trust and, to a much lesser extent, two Masters' Select funds for which Friess is a sub-adviser. This, along with my ownership interest and a long-term employment contract, tie my compensation as CEO and CIO to the long-term success of clients and shareholders."

To its credit, Brandywine incentives exclude assets under management. "We only accept new business when we know it won't impact our effectiveness in managing the assets already entrusted to us," says D'Alonzo.

The Brandywine Funds deserve the high scores they receive for board quality and fees as well. Six of the eight directors on the Brandywine Funds board are independent, and directors receive their compensation in fund shares. And expenses for the Brandywine Funds are lower than average when compared with their Morningstar peers. "Since 1974," says D'Alonzo, "we've maintained a single fee consistently with every one of our clients regardless of portfolio objective or asset size. We make no distinction between 'retail' and 'institutional' portfolios. We charge the same 1 percent fee for $10,000 shareholders and $200 million clients alike to maintain fairness and avoid any potential conflicts of interest." All Friess employees also pay the same 1 percent fee to own Brandywine shares.

Finally, Friess Associates' corporate communications are exactly what Morningstar looks for. Its shareholder report, which won the Mutual Fund Education Alliance's award for "Best Printed Shareholder Newsletter" for mid-size firms in 2004, includes detail and disclosure that go well beyond regulatory requirements. "In addition to discussing performance extensively, we exceed regulatory minimums regarding the frequency of communications and volunteer disclosure regarding items that also are not compulsory," says D'Alonzo.

For example, he says, Friess Associates began disclosing brokerage commissions in its annual and semiannual shareholder reports in September 2004. "We disclose commissions in gross dollar amounts and as a percentage of net assets. We also began highlighting fees in dollar terms in our annual and semiannual reports in advance of regulatory due dates."

Concludes Lutton: "Our stewardship rankings try to capture some of the intangibles associated with making an investment decision. While the grades are not intended to serve as buy/sell signals, when combined with other Morningstar analyst commentary, they can help determine the difference between a great investment and one to avoid."

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David Drucker is president of Drucker Knowledge Systems; see www.practicelifecycle.com and www.virtualofficenews.com.

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