Can a mutual fund manager loot your assets? Unnerved by the Madoff scandal, many investors are asking that question. But shareholders of major fund families, such as T. Rowe Price ( TROW) and Fidelity Investments, have no cause to fear Madoff-style swindles. Funds are required to keep transparent records, and the majority of companies have always complied with the rules. To be sure, not every fund has served the best interests of shareholders. As markets collapsed last year, it became clear that some managers had taken unsuitable risks. Other funds held appropriate investments but charged excessive fees. To decide whether you can trust a manager, consider the stewardship grades compiled by Morningstar. The fund tracker aims to determine whether companies are focused primarily on lining their own pockets or serving shareholders for the long term. Morningstar measures funds according to a series of criteria and awards grades ranging from A to F. Under the system, funds that run into problems with regulators get low marks, while those with clean hands receive A's. In addition, the Morningstar graders frown on boards that pay themselves high salaries. When the grading system was introduced in 2004, some fund executives scoffed. Shareholders shouldn't care about anything except total returns, the critics said. But recent market history suggests that clean managers may deliver the best results. During the three years ending in January, domestic equity funds with A ratings lost 11.8% annually. Though that may not seem like a winning performance, B-rated funds did even worse, losing 12.8%, and funds with lower grades finished further behind.
Morningstar analyst David Kathman says investors shouldn't buy a fund based solely on its stewardship grade. But he notes that funds with top grades have generally done better than lower-ranked competitors. "In the last several years, funds that invest for the long-term have outperformed funds with short-term focuses," he says. Some of the Morningstar criteria are subjective, and many investors may disagree with the scores. But the general approach is sound. Before buying any funds, investors should consider the Morningstar criteria. The goal should be to find fund managers who can be viewed as trusted business partners. Of the half dozen criteria considered by Morningstar, the most important may be for fees. Morningstar gives top grades to funds with expense ratios that fall in the cheapest 20% of their categories. Funds in the most expensive 40% get failing marks. The emphasis on fees is warranted. In order to be good fiduciaries, fund boards should insist on low fees. Because expense ratios are subtracted from returns, funds with low fees have a big advantage over competitors. Funds that gouge investors may trail the pack. Funds are also graded based on manager incentives. The Morningstar system prefers portfolio managers who have at least $1 million or one-third of their liquid assets invested in their own funds. Managers who have a stake in their funds will pay close attention to the welfare of shareholders, the thinking goes. To find data on the investments of portfolio managers, check statements of additional information, which are available on many fund Web sites.
The Morningstar analysts also aim to make subjective judgments about the corporate culture of fund companies. The analysts frown on companies that have constant manager turnover. Companies get low grades for introducing trendy choices, like funds focusing on hot areas such as nanotechnology. Instead, the analysts prefer funds with sensible strategies that are built to last for decades. Funds with A grades and strong 10-year performance records include Davis New York Venture ( NYVTX), Dodge & Cox Stock ( DODGX), T. Rowe Price New Horizons ( PRNHX) and Vanguard Wellington ( VWELX). Investors seeking a small value fund with an A grade should consider Royce Special Equity ( RYSEX). The fees are low, and portfolio manager Charles Dreifus has more than $1 million invested in the fund. Dreifus receives a performance bonus that is based partly on his five-year returns and risk. That gives the manager an incentive to take limited risks and aim to reward shareholders with long-term results.