From the November 2007 issue of Research Magazine • Subscribe!

November 1, 2007

Fiduciary Funds

Three years ago, Morningstar introduced what it calls its Stewardship Grades. Three years later, it is revising its ranking methodology.

Explains Laura Lutton, a Morningstar analyst and head of the committee overseeing the methodology changes: "A lot has changed in mutual funds' corporate governance. Some companies have taken steps to change the way they oversee their mutual funds and we wanted to be sure our methodology accurately reflects these industry changes."

Perhaps Lutton is being modest in that Morningstar's grades don't just reflect change; they cause it. Says Jim Laird, president and corporate CFO of the Diamond Hill fund family in Columbus, Ohio: "Our current grade was a B. Generally, Morningstar's commentary on our stewardship has been positive and we've scored excellent to fair on their five stewardship criteria." [Eds' note: Diamond Hill's new A grade was released after our interview.]

Morningstar has, in the past, applied the "fair" score to Diamond Hill's fees -- one of the five criteria considered in applying the Stewardship Grade. "Morningstar said our fees aren't cheap," says Laird. "As our assets have risen, though, we've cut fees in terms of basis points." When Morningstar first came out with its grades, adds Laird, the Diamond Hill family's funds were much smaller and they had difficulty lowering fees, but as the funds have grown, they've been able to make cuts, no doubt influenced by Morningstar's grading of its funds.

Morningstar hasn't changed the five ranking criteria it considers. "Our committee of five analysts sat down," says Lutton, "and said, 'if we could do it all over again, what would change?'" On the surface -- not a lot. The five criteria are still each fund family's corporate culture, fund manager incentives, board oversight, fees and regulatory history.

So if the criteria haven't changed, what has? The emphasis applied to each criterion, says Lutton. "The biggest change we made was deciding to double-count the corporate culture score." Previously, Morningstar awarded two points to each of the five criteria but, upon reflection, Lutton and her committee realized that funds earning excellent corporate culture grades also scored well in other areas. "We got feedback from mutual fund companies that corporate culture sets the tone. For example, if a family focuses on its investors and lets that focus drive its corporate culture, then it also tends to have strong board oversight, fair fees, few regulatory mishaps and earns good long-term returns for its shareholders." Hence, the major change is that fund families can now earn up to four points for their corporate culture.

Lutton and her team also reasoned that points shouldn't be awarded for a family's adherence to regulatory requirements. Wanting to maintain an overall 10-point scale, they took away the two points a family could previously earn for regulatory excellence and, instead, Morningstar now awards up to two negative points if a family ignores its regulatory obligations. "For example, if a fund family got caught up in the market timing scandal of 2003-04, they will see their regulatory grade reduced. Yet, you no longer get points for obeying the law," says Lutton.

Even before the new-system rankings were complete at the time we talked with Morningstar for this article, Lutton said she wouldn't be surprised to see Diamond Hill's grade rise from its previous "B" rating (as the table on the previous page, released after the interview, confirms).

"I would agree with the thinking that corporate culture is critical," said Laird, also interviewed prior to the release of Morningstar's rankings. "I hope what Morningstar sees when it looks at Diamond Hill is that, from the beginning, we've done our best to align our interests with those of our shareholders."

How does it do that? "Everyone at Diamond Hill must adopt our approach to personal securities trading in order to comply with our code of ethics," says Laird. Indeed, employees cannot buy any security that's eligible for purchase by the family's funds -- meaning just about any individual stock or bond. Further, the fund family's board passed a policy that shares given to trustees in payment for their services must remain in their possession as long as they serve on the board. "We want our employees and trustees investing in our mutual funds, and we have largely achieved that goal."

Second, Diamond Hill's board of trustees has an independent chairman and board members; no insiders participate on the board. "We believe the role of a mutual fund board is critical, and independents play an important part. We try to be as open and clear as possible in our communications with clients." When the markets and the family's funds are struggling, for example, Laird says investors receive timely commentary from Diamond Hill. "And if we're not doing a good job, we admit we made a mistake."

Did Morningstar alter its approach to its other grading criteria? "We considered each area, but made few changes," says Lutton. "We still grade fund managers on whether they're getting paid to deliver good long-term results rather than grow assets or take other actions that aren't in their shareholders' best interests. We still believe fund managers should 'eat their own cooking.'"

As for the fees criterion, Lutton's group made a slight change. "We used to look at the trend of a fund's fees -- for example, did fees fall as the asset base grew, passing along economies of scale to investors? But, as with a fund's regulatory history, we reasoned that we shouldn't reward a fund for passing along economies because everyone should be doing that; that's just the way the industry should work." So under the new methodology, says Lutton, Morningstar will just look at the fund's cost. "What we know from all our research is that low [absolute] fees are one of the best predictors of outstanding fund performance. If a fund charges lower fees, then the manager has a lower hurdle to clear. Vanguard's managers don't have to take on the same risk as another firm that charges more for its funds."

Lutton says they made minor changes to the fund board criterion, too. "To get full credit, or two points, a fund needs to have an independent chairman and what the SEC calls a 'super majority' [75 percent] of independent directors. This was the SEC's position when we first launched the Stewardship Grades, but it was later challenged by the big players -- like Fidelity and Vanguard -- both of which were vocal opponents." One reason it's important for funds to have independent leadership, says Lutton, is evident from the issue of negotiating a fund's fees. "Obviously, it's in a fund company's interest to charge more because that brings in more revenue. But the fund's board should do the right thing for shareholders and push for lower fees."

Another change in Morningstar's approach to the board of trustees issue relates to its former emphasis on the number of funds that were overseen by a board. "We were concerned that fund company boards overseeing dozens of funds [were spread too thin]," says Lutton. "Directors might have full-time jobs and lack the capacity to give each individual fund adequate attention. So we used to lower scores for boards having too many funds on their plate, or what we referred to internally as the 'workload factor.'"

As a result, some fund families have created committees dividing up directors and assigning groups to different fund categories, such as international or fixed-income or domestic stocks. By dividing up the work, they are more likely to dig deeply into each fund. "We think that's great," says Lutton, "but at the end of the day we decided the structure that works well for one fund company might not work for another and that the true criterion should be 'what are these boards getting done for their shareholders?' That's what a good ranking now depends upon."

So will any funds fall in their rankings as they move from the old to the new system? "Overall, we believe grades will go down," says Lutton. "It will be rare for fund families to get straight As for all their funds. Many of Vanguard's funds, for example, will get As, but probably not all of them. Some funds may stay the same, though, as they get four points for their corporate culture while incurring no negative points for their regulatory history," citing fund families such as Dodge & Cox, the Davis funds and FPA Capital.

How much will all of this matter to the funds? "I don't know if the Stewardship Grades have contributed to our success or not," says Laird. "Morningstar is clearly well regarded by independent financial advisors as well as brokers, and we strongly suspect they pay attention to these grades."

Three years ago, Morningstar introduced what it calls its Stewardship Grades. Three years later, it is revising its ranking methodology.

Explains Laura Lutton, a Morningstar analyst and head of the committee overseeing the methodology changes: "A lot has changed in mutual funds' corporate governance. Some companies have taken steps to change the way they oversee their mutual funds and we wanted to be sure our methodology accurately reflects these industry changes."

Perhaps Lutton is being modest in that Morningstar's grades don't just reflect change; they cause it. Says Jim Laird, president and corporate CFO of the Diamond Hill fund family in Columbus, Ohio: "Our current grade was a B. Generally, Morningstar's commentary on our stewardship has been positive and we've scored excellent to fair on their five stewardship criteria." [Eds' note: Diamond Hill's new A grade was released after our interview.]

Morningstar has, in the past, applied the "fair" score to Diamond Hill's fees -- one of the five criteria considered in applying the Stewardship Grade. "Morningstar said our fees aren't cheap," says Laird. "As our assets have risen, though, we've cut fees in terms of basis points." When Morningstar first came out with its grades, adds Laird, the Diamond Hill family's funds were much smaller and they had difficulty lowering fees, but as the funds have grown, they've been able to make cuts, no doubt influenced by Morningstar's grading of its funds.

Morningstar hasn't changed the five ranking criteria it considers. "Our committee of five analysts sat down," says Lutton, "and said, 'if we could do it all over again, what would change?'" On the surface -- not a lot. The five criteria are still each fund family's corporate culture, fund manager incentives, board oversight, fees and regulatory history.

So if the criteria haven't changed, what has? The emphasis applied to each criterion, says Lutton. "The biggest change we made was deciding to double-count the corporate culture score." Previously, Morningstar awarded two points to each of the five criteria but, upon reflection, Lutton and her committee realized that funds earning excellent corporate culture grades also scored well in other areas. "We got feedback from mutual fund companies that corporate culture sets the tone. For example, if a family focuses on its investors and lets that focus drive its corporate culture, then it also tends to have strong board oversight, fair fees, few regulatory mishaps and earns good long-term returns for its shareholders." Hence, the major change is that fund families can now earn up to four points for their corporate culture.

Lutton and her team also reasoned that points shouldn't be awarded for a family's adherence to regulatory requirements. Wanting to maintain an overall 10-point scale, they took away the two points a family could previously earn for regulatory excellence and, instead, Morningstar now awards up to two negative points if a family ignores its regulatory obligations. "For example, if a fund family got caught up in the market timing scandal of 2003-04, they will see their regulatory grade reduced. Yet, you no longer get points for obeying the law," says Lutton.

Even before the new-system rankings were complete at the time we talked with Morningstar for this article, Lutton said she wouldn't be surprised to see Diamond Hill's grade rise from its previous "B" rating (as the table on the previous page, released after the interview, confirms).

"I would agree with the thinking that corporate culture is critical," said Laird, also interviewed prior to the release of Morningstar's rankings. "I hope what Morningstar sees when it looks at Diamond Hill is that, from the beginning, we've done our best to align our interests with those of our shareholders."

How does it do that? "Everyone at Diamond Hill must adopt our approach to personal securities trading in order to comply with our code of ethics," says Laird. Indeed, employees cannot buy any security that's eligible for purchase by the family's funds -- meaning just about any individual stock or bond. Further, the fund family's board passed a policy that shares given to trustees in payment for their services must remain in their possession as long as they serve on the board. "We want our employees and trustees investing in our mutual funds, and we have largely achieved that goal."

Second, Diamond Hill's board of trustees has an independent chairman and board members; no insiders participate on the board. "We believe the role of a mutual fund board is critical, and independents play an important part. We try to be as open and clear as possible in our communications with clients." When the markets and the family's funds are struggling, for example, Laird says investors receive timely commentary from Diamond Hill. "And if we're not doing a good job, we admit we made a mistake."

Did Morningstar alter its approach to its other grading criteria? "We considered each area, but made few changes," says Lutton. "We still grade fund managers on whether they're getting paid to deliver good long-term results rather than grow assets or take other actions that aren't in their shareholders' best interests. We still believe fund managers should 'eat their own cooking.'"

As for the fees criterion, Lutton's group made a slight change. "We used to look at the trend of a fund's fees -- for example, did fees fall as the asset base grew, passing along economies of scale to investors? But, as with a fund's regulatory history, we reasoned that we shouldn't reward a fund for passing along economies because everyone should be doing that; that's just the way the industry should work." So under the new methodology, says Lutton, Morningstar will just look at the fund's cost. "What we know from all our research is that low [absolute] fees are one of the best predictors of outstanding fund performance. If a fund charges lower fees, then the manager has a lower hurdle to clear. Vanguard's managers don't have to take on the same risk as another firm that charges more for its funds."

Lutton says they made minor changes to the fund board criterion, too. "To get full credit, or two points, a fund needs to have an independent chairman and what the SEC calls a 'super majority' [75 percent] of independent directors. This was the SEC's position when we first launched the Stewardship Grades, but it was later challenged by the big players -- like Fidelity and Vanguard -- both of which were vocal opponents." One reason it's important for funds to have independent leadership, says Lutton, is evident from the issue of negotiating a fund's fees. "Obviously, it's in a fund company's interest to charge more because that brings in more revenue. But the fund's board should do the right thing for shareholders and push for lower fees."

Another change in Morningstar's approach to the board of trustees issue relates to its former emphasis on the number of funds that were overseen by a board. "We were concerned that fund company boards overseeing dozens of funds [were spread too thin]," says Lutton. "Directors might have full-time jobs and lack the capacity to give each individual fund adequate attention. So we used to lower scores for boards having too many funds on their plate, or what we referred to internally as the 'workload factor.'"

As a result, some fund families have created committees dividing up directors and assigning groups to different fund categories, such as international or fixed-income or domestic stocks. By dividing up the work, they are more likely to dig deeply into each fund. "We think that's great," says Lutton, "but at the end of the day we decided the structure that works well for one fund company might not work for another and that the true criterion should be 'what are these boards getting done for their shareholders?' That's what a good ranking now depends upon."

So will any funds fall in their rankings as they move from the old to the new system? "Overall, we believe grades will go down," says Lutton. "It will be rare for fund families to get straight As for all their funds. Many of Vanguard's funds, for example, will get As, but probably not all of them. Some funds may stay the same, though, as they get four points for their corporate culture while incurring no negative points for their regulatory history," citing fund families such as Dodge & Cox, the Davis funds and FPA Capital.

How much will all of this matter to the funds? "I don't know if the Stewardship Grades have contributed to our success or not," says Laird. "Morningstar is clearly well regarded by independent financial advisors as well as brokers, and we strongly suspect they pay attention to these grades."

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David J. Drucker, CFP, is president of Drucker Knowledge Systems; see www.DavidDrucker.com

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