In 2004, independent investment research company Morningstar Inc. introduced a Fiduciary Grade (subsequently renamed as the Stewardship Grade) system to complement its ratings service of mutual funds by factoring in areas of mutual fund governance and operations. The stewardship grades have no influence on its star ratings - they are two separate tools for appraising a mutual fund.

SEE: Morningstar Lights The Way

Investors use Morningstar Rating™ as a signpost of mutual fund performance in terms of both return and risk. These ratings are a valuable tool for objectively comparing the performances of different mutual funds. Read on as we cover this Morningstar service and what is means for investors.

In 2003, former New York attorney general Elliott Spitzer launched actions against some mutual fund companies for allowing their privileged clients to profit from improper activities such as late trading. In its wake, investors realized they needed more than the past performance-based ratings to assess mutual funds.

A Morningstar rating does not get at critical intangibles such as how seriously the mutual fund company takes its fiduciary responsibility to mutual fund shareholders. Or, how aligned the interests of the mutual fund manager and the mutual fund company are with those of the fund investor?

To address this need, Morningstar created the Stewardship Grade in 2004 to look at the regulatory issues, board quality, manager incentives, fees and corporate culture of mutual funds. The company revised its grading system in September 2007, imposing new, tougher standards.

How the Mutual Funds are Graded
The Morningstar Stewardship Grade is based on the evaluation of five areas critical for mutual fund governance and operations. Morningstar generally assigns to mutual funds points ranging from 0 (Very Poor) to 2 (Excellent) in increments of 0.5 for each of these five areas. There is no general consensus among investment professionals as to what constitutes a "favorable" rating. However, logic suggests that funds with an overall rating of A or B would be preferable to those with lesser grades.

The scores of each of the five areas are aggregated and the mutual fund is assigned a Stewardship Grade based on the total number of points:

F=2.5 or less

1. Regulatory Issues: Morningstar examines whether the mutual fund company has had any regulatory issues within the past three years. If so, what corrective actions has the mutual fund company implemented?

2. Board Quality: Morningstar looks for a demonstrated track record of the mutual fund board in protecting the interests of mutual fund investors. Mutual funds get kudos if their independent directors invest in the mutual funds.

3. Manager Incentives: This score is based on Morningstar's evaluation of mutual fund ownership and compensation structure. Mutual funds in which the fund's manager owns a meaningful stake in the fund score high on the fund ownership dimension. A compensation structure that rewards the mutual fund manager for long-term mutual fund performance is favored.

4. Fees: Mutual funds are rewarded for having expense ratios lower than those of their peers and for effectively reducing their expense ratios with asset growth.

5. Corporate Culture: Morningstar looks for tangible evidence that the mutual fund company takes its fiduciary responsibility seriously. Among the factors it considers are softer issues like whether the company closes mutual funds when they get too large and whether the company starts trendy mutual funds to garner assets.

Using the Morningstar Stewardship Grade

1. Buy and Hold Investors: Buy and hold mutual fund investors first need to examine how mutual funds in their portfolios stack up on the two measurements - Morningstar rating and Stewardship Grade.

Mutual funds that rank favorably on both dimensions may be retained and mutual funds that rank unfavorably on both dimensions may be replaced by ones that rank favorably.

For mutual funds that rank favorably in one dimension but not in the other, the answer is not so clear-cut. Retaining a fund with a strong Morningstar rating but lower Stewardship Grade is a matter of personal choice. Conversely, a mutual fund's Fiduciary Grade may be satisfactory but the Morningstar rating may be unfavorable. This may just be a case of the mutual fund manager going through a temporary bad patch. Investors have to weigh these factors along with tax consequences before deciding to sell a mutual fund.

Given the number of mutual funds available, investors seeking new mutual funds to add to their portfolios should, in general, have no trouble in finding mutual funds with a favorable Morningstar rating as well as a Stewardship Grade.

2. Tactical Asset Allocators: A tactical asset allocators uses an active investment strategy and typically invests in mutual funds such as sector funds. Because tactical asset allocators seek superior performance during their mutual fund holding period, factors such as superior long-term performance, which determine a Morningstar rating, are less important to them. However, these investors typically seek to own mutual funds within a single family for administrative ease. As such, tactical asset allocators will find the Stewardship Grade useful in evaluating and choosing mutual fund families to implement their strategies.

What's it worth?
The Stewardship Grade system is a blend of several metrics. The grading of mutual funds on regulatory issues is backward-looking and, as such, may not be a prognosticator of potential future trouble. The grading system includes a quantitative dimension in mutual fund fees. Also included are qualitative dimensions such as mutual fund corporate culture, manager incentives and the quality of the board of directors.

While Morningstar rating does an excellent job of objectively evaluating past performance, financial markets do not allow the investor to predict future performance based on these ratings alone. Many times, funds with a rating of four or five stars do not live up to their expectations.

Investors will find the Stewardship Grade system valuable in their mutual fund decision-making process, if only as a tool for comparing different mutual funds. The Stewardship Grade provides mutual fund shareholders with much-needed insight into the governance and operations of mutual funds. The system is a good first step and may improve as Morningstar continues to refine the Stewardship Grade system over time.

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