Making the Grade

n August, 2004 Morningstar introduced the "Stewardship Grade". Designed as a 5 letter academic scale, where A is the highest grade and F the lowest, it's sure to rekindle some unpleasant "report-card-discussion-at-dinnertime" memories.

The five components of the Overall Stewardship Grade include (1) an assessment of the fund's entanglements (or absence thereof) with regulators over the past three years, (2) the quality of the fund's board of directors, (3) manager incentives and manager ownership of fund shares, (4) expenses incurred by the fund, and (5) shareholder-focused management, or as Morningstar calls it - "corporate culture". Funds receive a rank of Excellent, Good, Fair, Poor, or Very Poor in each of the five components. Funds that receive an Overall Stewardship Grade of "A" tend to receive the rank of Excellent in at least three of the five categories, whereas those funds receiving an "F' grade typically receive a Poor or Very Poor in each of the five components.

The Stewardship Grade was a long time coming and arrived none too soon. Its arrival was undoubtedly hastened by a troubling trend of corporate misbehavior (e.g. Adelphia, Enron, WorldCom, Tyco, and a packet of others) followed by the mutual fund industry being tainted by some firms' illegal trading practices. Thus, the stewardship grade is an attempt to look deeper into the heart of a fund's operation, with an ultimate goal of gaining a sense of the ethics and integrity of overall fund management.

Assuming that good stewardship might be related to good performance, this article examines the correlation of the Overall Stewardship Grade with several key fund variables, namely 3-year return, manager tenure, expense ratio, front-end load, and net assets.

As of June 30, 2005 there were 629 distinct, domestic (i.e. US) equity funds in the Morningstar Principia database that had been assigned an Overall Stewardship Grade and which had a three-year performance history. Funds assigned to following Morningstar Categories were removed: Specialty Funds, Convertibles, Conservative Allocation, and Moderate Allocation. Thus, there were 504 distinct U.S. equity funds included in this analysis. There were not a sufficient number of midcap value funds with a C-F grade to conduct a meaningful comparison of means, so the total number of funds in the means analysis was 485.

As shown in the table "The Value of Good Stewardship", there are marked differences between means for funds that received a high overall stewardship grade (an A or B grade) compared to funds that received a C, D, or F grade.

In every case the average 3-year, load-adjusted total return was higher for the A and B funds. Moreover, the difference in return between the high and low grade funds was statistically significant in each case (as noted by the yellow shading). A summary of the performance advantage of funds with high stewardship grades is provided in the graph titled "The Upper Road".

In all but one case, average manager tenure was higher for funds with an A or B overall stewardship grade. Funds with a high overall stewardship grade tend to have lower expense ratios than funds with low stewardship grades, and in most cases, the differences in the expense ratio are statistically significant at the 90% or higher confidence level. Interestingly, funds with a lower stewardship grade (C, D, or F) typically have higher front-end loads and fewer net assets. The linkage between low stewardship grades and fewer net assets is highly related to performance. In other words, funds with low stewardship grades tend to have worse load-adjusted performance. Funds whose performance lags find it much more difficult to attract and keep assets.

The overall stewardship "grade point average" (or "GPA") for the sample of 504 distinct U.S. equity funds was 2.44, or about the equivalent of a C+ (see table "Grade Distribution"). Roughly 9% of the sample was assigned an overall stewardship grade of A. The grade of A is assigned 4 GPA points. The grade of B is assigned 3 points, C is 2 points, D is 1 point, and a grade of F receives zero points. The overall GPA is simply the average of the assigned grade points. Interestingly, the net-asset weighted GPA for this sample of 504 funds was 2.81, reaffirming the notion that larger funds tend to have higher stewardship grades. A total of $1.77 trillion in net assets was held by the 504 funds in this study.

Nearly 45% of the funds received a grade of B, almost 31% received a C, 12.7% received a D grade, and 3% got an F. Roughly 54% of the funds had an A or B grade and about 46% of the sample received a C, D, or F overall stewardship grade, suggesting that the grade distribution is negatively skewed (i.e. more A and B grades were assigned than D and F grades).

In conclusion, fund families are ranked by the average GPA of their funds (see the table "The Lineup"). Each fund family needed to have at least five funds in the sample to be included in this table. Fund families with strong overall stewardship grades included Bridgeway, Wasatch, Royce, T. Rowe Price, Baron, Oppenheimer, and Vanguard. Fund families whose funds had the lowest average stewardship grades were Alliance Bernstein, Columbia, Evergreen, Wells Fargo, PBHG, and Federated.

It is important to note that of the 3,737 distinct, domestic equity funds in the 6/30/05 Morningstar database only 641 (or 17%) were assigned an Overall Stewardship Grade. As more funds are assigned a stewardship grade it will be possible to conduct analysis that is more robust in terms of sample size.

There is satisfaction and reassurance in finding evidence that good behavior and good performance are not mutually exclusive.

The Value of Good Stewardship

Larger mean in bold.  Boxes highlighted in yellow indicate that the two different means are statistically different at or above the 90% confidence level.

The Upper Road

Grade Distribution

The Lineup

* Fund families included in table had at least five funds with an Overall Stewardship Grade

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Craig L. Israelsen, Ph.D. is an associate professor at Brigham Young University. He teaches family finance in the Department of Home and Family Living. His research interests include mutual fund analysis. He writes monthly for Financial Planning magazine.