Morningstar Eyes Intangibles in New Fund Ratings

The firm's new categories assess the "key intangibles" of mutual funds: regulatory issues, board quality, management incentives, fund fees and corporate culture.

Morningstar, a company that has been analyzing and rating mutual funds since 1984, and publishing its findings online for most of the past decade, recently added some subjective measures to the long list of items it examines. Morningstar has built its business on awarding funds between one and five stars, based on their financial performance, and providing in-depth reports on each fund.

Now, the firm is adding five new categories: regulatory issues, board quality, management incentives, fund fees and corporate culture. In each category, a fund gets one of five ratings, ranging from excellent to very poor.

The new measures are available online to Morningstar premium customers. The traditional star ratings can be viewed at the Morningstar site after a free registration, but looking at the fiduciary grades requires a premium membership, which costs $12.95 a month or $115 a year.

During the rollout, the new measures will be applied only to the largest funds, currently more than 600. Morningstar expects to expand the number of funds with grades in the coming months. Eventually, it will grade about 2,000 funds, representing about 90 percent of fund assets.

Participating fund managers must fill out a comprehensive questionnaire, which is then analyzed in depth by Morningstar personnel.

The Fiduciary Grades assess what Morningstar calls "key intangibles," such as the quality of a funds board of directors or a fund firms corporate culture, which Morningstar analysts believe can make the difference between a great investment and one to avoid.

The grades, which follow the school grading system of A through F, are not meant to be used in isolation or as buy/sell signals when looked at on their own. Rather, Morningstar representatives say they represent an addition to their suite of investing research and tools, along with the Fund Analyst Reports and Morningstar Rating for funds. The classic star ratings will not be based on the Fiduciary Grades.

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When assigning the grade for regulatory issues, Morningstar analysts examine each firms record to determine whether it has run afoul of regulators in the past three years. They also assess the gravity of the allegations and the subsequent reforms that the firm has undertaken. If one firm has done a better job than another at addressing its role in, for example, the recent fund scandals, it will receive a higher grade.

Rating the quality of the board of directors is based on factors such as the number of funds that directors oversee, the relationships between directors and fund firms, and the performance of trustees in looking after fund shareholders interests. Morningstar also will examine whether trustees are investing alongside fund holders.

Morningstar has been asking fund companies to complete a survey detailing the structure of fund managers pay as well as the level of their investment in fund shares. This data goes into their measurement of manager incentives. Though the analysis doesnt look at specific salary figures, it does examine performance incentives and the bonus structure.

A fund manager who is paid to beat an aggressive benchmark over a one-year period, for example, might be inclined to take much bigger risks than he or she otherwise would. The ratings also reward managers who "eat their own cooking" by investing in either the funds they run or other offerings run by their firm. The belief is that managers who invest alongside fund shareholders are more likely to pay closer attention to issues such as expenses and taxes than ones who do not.

In the expense arena, Morningstars tests examine whether fund investors are getting a good deal or the short end of the stick. They look at how a funds expenses stack up relative to its peers, as well as trends in expenses to gauge whether a firm is appropriately passing on economies of scale to a growing funds shareholders. The scoring for this factor is within category and within distribution channel because the analysts hope to compare apples with apples.

To examine corporate culture, Morningstar is looking at how shareholder-focused the management is by looking for tangible evidence that a firm has an in-depth understanding of its role as a fiduciary. This is the most subjective component of the grade by virtue of the sheer number of factors that can influence the depth of a firms commitment to its fund holders.

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The analysts evaluate criteria such as the quality of shareholder reports, a firms willingness to close funds at appropriate asset levels, and the pattern of new fund launches. Also under the microscope are the ways fund companies deal with these issues to gauge whether the firm has consistently focused on the long-term interests of fund shareholders. The mutual fund firms usage of redemption fees and the ability to retain key personnel are part of this measure as well.

A detailed description of the components of the fiduciary grades can be found here in PDF form.

Of the approximately 600 funds Morningstar has rated to date, about 10 percent got an A; almost 4 percent got an F; and the rest got a B, C or D.

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