Most fund directors are aware that Morningstar assesses the governance and ethics of mutual funds by assigning a Stewardship Grade. This process was started about five years ago but has recently been rejuvenated and reemphasized. Morningstar’s overall intent with the grades is to “shine a light on better/best practices.” They have currently rated about 1,000 out of 7,000 funds representing about 30% of all fund assets.

The rejuvenation of this grading stems from the fact that Morningstar has proven, to its satisfaction, that Stewardship Grades are highly correlated with their better known Star Ratings. Of course, the Star Ratings have been an important factor in the growth of a fund’s assets. The Stewardship Grade is a consideration which potential investors might want to take into account.

During five years of producing the Stewardship Grades, Morningstar has refined the criteria which go into them. For example, when the grades were first introduced the number of funds governed by a single board was a determinative factor; the more funds governed, the lower the grade. This has been changed from an absolute criterion to one which is taken into account along with numerous other variables. This provides an example of how subjective the Stewardship Grades can be and how important it is for fund groups to take an interest in how these grades are assessed.

Virtually all of the criteria Morningstar uses for its well-known Star Ratings are quantitatively measured. The investment category into which a fund falls is predominantly determined by objective criteria such as the price earnings ratio and the capitalization of the underlying investments. For fixed income funds it is determined by, among other things, the duration of the underlying bond and the credit quality of the issuer. With these quantitative measures there is not much to argue about. However when there is, investment managers spend a great deal of effort to ensure that their fund is fairly rated and placed in the appropriate category.

With Stewardship Grades, more subjective judgment goes into Morningstar’s assessment. Fund boards should take a lot of care to obtain the best possible rating and to present the facts about their funds’ governance in the best possible light. Morningstar makes a point to be available to discuss particular grades. They are always interested to learn how fund directors interpret the elements which are taken into account by their analysts when compiling each grade.

The criteria that Morningstar uses to determine Stewardship Grades include (1) corporate culture, (2) fees and expenses, (3) board quality, (4) manager incentives, and (5) regulatory issues. To arrive at a Stewardship Grade, points are tallied across all five components. The maximum score is 10 points. The numeric score is then converted to a letter grade in a process that weights relatively good performance among other funds that have been similarly graded. The components of the Stewardship Grades are discussed below.
• Corporate Culture  This is the highest scoring component with a maximum of 4 points. Morningstar looks for a history of putting the fund shareholder’s interests first, particularly whether small individual shareholders receive the same treatment as large institutional shareholders. The rapidity and frequency of management changes are an important consideration as are any regulatory or legal scandals. Rapid trading patterns are a consideration especially if the manager has an affiliated broker dealer. Another indication is the clarity and precision of the prospectus language. Morningstar seems to be particularly interested to see that market timing is discouraged through the adoption of short-term redemption fees.
• Fees (and Expenses)  Fees, board quality, and manager incentives each carry a maximum score of 2 points. Fees and expenses are evaluated by reference to a fund’s peer group of similarly sized funds (usually categorized within the same Morningstar Style Box). Typically Morningstar compares average effective management fees, or the initial or starting management fees. The sharing of economies of scale through the existence of break points in the management fee as assets in the fund rise is an important consideration. The total expense ratio compared to a fund’s peers is very important as is the degree to which expenses are voluntarily capped.
• Board Quality  The span of control of the board is a consideration in this component as is the relationship of the individual directors to the manager. For example, independent directors who are former executives of the management tend to be frowned on. The existence of an independent chair is deemed a virtue as is a record of standing up to the management company over issues which impact the fund shareholders. Compensation substantially in excess of directors of similar funds or the existence of retirement benefits tends to detract from this component. Sensible mandatory retirement ages or term limits may be viewed as a virtue. A practice of directors investing in the funds they govern is desirable.
• Manager Incentives  Morningstar believes that the absolute amount and structure of compensation of the portfolio managers and other key executives is an important consideration. The absolute amount of compensation should be high enough to ensure that high quality executives are attracted, motivated, and retained. Compensation through base pay, bonus, and equity-based pay should be structured to ensure that fund executives are motivated to serve the fund shareholder well. Too great an emphasis on management company profits may detract from the motivation to deliver better than average returns to the fund shareholders.
• Regulatory and Legal Issues  Scandals, adverse regulatory and legal settlements, and even unflattering press coverage may detract from this component of the Stewardship Grade. Furthermore the manner in which such settlements are made can indicate whether or not the manager actually embraces transparency.

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MPI offers consulting services to fund boards that want to better understand their Stewardship Grades or seek to improve them.