Morningstar stewardship ratings sink

The number of mutual funds receiving the highest possible stewardship grades from investment research provider Morningstar Inc. dropped, while the number receiving the lowest grades increased as a result of the company’s Sept. 25 revision of its grading system to impose new, tougher standards.

“We’ve got some companies that are leading the industry in stewardship, and others that have a way to go,” said senior fund analyst Laura Pavlenko Lutton.

Beginning in 2004, Morningstar has handed out stewardship grades to mutual funds designed to help assess how well fund managers and fund companies align their interests with those of their shareholders.

Under the new criteria, just 6% of funds received A’s, while 24% received B’s, Ms. Lutton said. Prior to the new standards, 9% had gotten A’s and 44% had received B’s. Those numbers correspond with a rise in the number of funds that received F’s and D’s. Under the new criteria, 3% of funds got F’s, and 20% received D’s, Ms. Lutton said. Previously, 1% had received F’s and 9% had received D’s.

Under the new standards, a fund company’s corporate culture is given more weight than it once was. While it remains a subjective determination of a firm’s investing and business culture, Chicago-based Morningstar found that corporate culture sets the tone for the other components of a mutual fund it evaluates, so that criterion now accounts for 40% of the grade, up from 20% originally.

Fund boards are now held to a higher standard for independence, too.

Boards must have independent chairmen, and 75% of their directors must be independent to receive full credit for the category.

Meanwhile, the current level of fees now solely determines a fund’s expense score. Previously, Morningstar took into account the direction in which a fund’s fees were headed.

Finally, firms now lose points for regulatory issues and no longer receive points toward their overall stewardship grade for simply following the law. Firms with poor regulatory histories also lose points.

The fifth category, manager incentives, remains unchanged.

Most funds received B’s before the new standards were implemented, but most now receive C’s, Ms. Lutton said.

One of the biggest losers as a result of the tougher standards was Fidelity Investments of Boston.

Fidelity’s funds aren’t overseen by a board with an independent chairman, she said. Instead, the board chairman is Edward C. “Ned” Johnson III, chairman and chief executive of FMR Corp., which runs Fidelity.

Also, Fidelity took a hit because the New York- and Washington-based Financial Industry Regulatory Authority, formerly known as NASD, and the Securities and Exchange Commission are still investigating the firm’s equity traders for gifts they received from brokers. In addition, they are focusing on the traders’ business relationships with brokers who are also family members, Ms. Lutton said.

Putnam Investments of Boston also saw some of its funds drop a grade, she said.

A small number of the firm’s funds received F’s, while the majority got D’s.

“They have had so much manager turnover,” Ms. Lutton said. “We just have some concerns about the culture there.”

Two success stories are the Clipper Fund and Selected American Shares, both managed by Davis Selected Advisers LP of Tucson, Ariz.

They were the only two funds to receive perfect stewardship grades.

Other funds received A’s in some categories. But a fund’s stewardship grade is an average of the grades given in the five underlying categories, and Clipper and Selected American Shares were the only funds to receive A’s in all five.

At least one industry expert, however, questioned the usefulness of the grades.

There are no data to support the claim that a fund with a good stewardship rating will outperform, said James Lowell, co-founder of The Rankings Service in Needham, Mass. The ranking system is based on the track records of mutual fund managers over the course of their careers.

Ms. Lutton concedes his point. Morningstar is working to rectify that problem, but because the stewardship grades only go back to 2004, data showing any long-term trends are still unavailable, she said.

But absent those data, Ms. Lutton said there is still a big reason to want to make sure a fund receives a good stewardship grade.

“I think your nest egg is a precious thing,” she said. “Why wouldn’t you invest in a fund that treats you as an owner rather than just another dollar that comes through the door?”

At least one financial adviser agrees.

“I don’t think [stewardship grades are] a bad idea. We went though a period of time where a number of companies got a black eye because of poor behavior,” Stephen Gorman, president of Gorman Financial Management Inc. in Hingham, Mass., said, referring to the mutual fund trading scandals that emerged in 2003.

David Hoffman can be reached at [email protected].