How do you know if a mutual fund is making more money for you or its management team?For the average Joe, it's not easy. But Morningstar's ( MORN) stewardship ratings grade funds on intangibles like corporate culture, board quality, manager incentives, fees and regulatory history -- in short, how well they care for investors' capital. Over the summer, the Chicago fund-research company revamped its three-year-old grading system to give more weight to corporate culture and stop rewarding firms for simply obeying the law. Previously, all five categories provided an equal 20% of a fund's total grade. But after revamping the criteria, the corporate culture weighting in the grade doubled to 40%, because this sets the tone for everything else. Laura Lutton, a senior fund analyst at Morningstar, says corporate culture measures how closely the portfolio manager's financial interests align with the shareholders'. "Is the fund investor-driven or sales-driven? Does the manager get paid based on the fund's performance or his ability to grow assets?" She says the retention rate of fund managers is also a factor. Meanwhile, funds' regulatory histories are now graded on a demerit system. The best a fund with a clean record can hope for on the regulatory front is a grade of zero; funds that have been involved in scandals or had run-ins with the Securities and Exchange Commission will see their total grade decline.
After each category is graded and added up, funds receive an overall grade from "A," for best in class, to "F," for failure. After grading 1,000 funds under the new methodology, only two received perfect scores: ( CFIMX) The Clipper fund and ( SLADX) Selected American (SLADX). The average grade of C was assigned to 47% of the 1,000 funds. Lutton says many of the Weitz family of funds were downgraded to B from A, reflecting their high fees and for not using performance as the basis for their fund managers' pay. Fidelity Investments, which received a lot of Bs last year, is now getting mostly Cs. It lost points due to the SEC's investigation into its trading desk and because its board chairman is not independent. And Putnam, which had been getting Cs, is now earnings just Ds and Fs, because its corporate culture grade fell. In addition, Puntam has the lowest manager retention rate of the large fund families, says Lutton. Meanwhile, Diamond Hill funds jumped from the B-level up to the head of the class because its fees have been falling. Turning to the other criteria, fund boards are graded on their level of independence. Full credit goes to boards with independent chairmen and 75% independent directors. Morningstar asks whether board members invest in the fund and negotiate for lower fees. Do they have a plan to close the fund should it grow too large? (This last question is important; depending on the strategy or asset class, it can be difficult to put large sums of money to work as profitably as smaller sums.) In terms of fees, funds in the cheapest 20% of the universe receive full credit, while funds more expensive than 60% of their peers get no credit. That's because fees are one of the biggest factors in predicting which funds will outperform over the long-term. Finally, Morningstar wants to show whether fund managers' interests are aligned with shareholders'. There's a built-in incentive to grow assets, since the bigger the fund, the more management fees they collect. But it can be easier to grow through marketing, rather than appreciation. So Morningstar asks whether managers invest in their own funds.
For funds classified as "core" holdings, it wants to know if the managers invest at least $1 million. Morningstar is better known for its five-star ratings, which look at funds' performance, risk and cost. But for many people, the Stewardship Grade could be a much more important factor in determining what fund to buy. After all, past results are no guarantee of future returns. While it's unlikely a poor performing fund will turn around to become a star, it's not uncommon for this year's superstar to become next year's dud. And funds that put investors' interests first are likely to outperform over time. Management companies with one or more funds at the top of the class include, in alphabetical order, Clipper, Columbia Acorn, Davis, Diamond Hill, Dodge & Cox, FPA Paramount, Longleaf Partners, Oakmark, Pennsylvania Mutual, Royce, Selected American, T. Rowe Price ( TROW)and the Vanguard Group. Companies with at least one fund at the bottom of the barrel included AIM, DWS, Evergreen, Federated Investors ( FII), Pioneer and Putnam. Among the best of class in all five categories were ( DODGX) Dodge & Cox Stock (DODGX), ( NYVTX) Davis New York Venture (NYVTX), ( PRGFX) T. Rowe Price Growth Stock ( PRGFX) and ( VGEQX) Vanguard Growth Equity (VGEQX). The worst in class is ( KAUFX) Federated Kaufmann (KAUFX). Lutton says the fees are too high considering the fund's size of $11.1 billion. In addition, the fund has done little to remedy problems from its participation in the market timing scandal in 2004. ( AMIFX) AIM Income (AMIFX) also got an overall score of F because it received a D for corporate culture and an F for fees. ( PCAPX) Putnam Capital Appreciation (PCAPX) and ( MOMGX) Pioneer Growth Shares (MOMGX) also fared very poorly.