A tool to protect your clients, and yourself.
In the wake of the 2003 mutual fund scandal, fiduciary responsibility has suddenly become as hot as baseball's steroid scandal. So it's not surprising that mutual fund monitoring services have started rating and measuring fund complexes based upon their responsiveness to fiduciary concerns.
Investment companies with high fiduciary ratings tend to have
solid-performing stock funds. But since fiduciary ratings are new, the
relationship between performance and fiduciary ability is not written
in stone. Indeed, some might argue that, at present, fiduciary ratings
are more art than science.
Nevertheless, the new ratings give financial
advisors new tools to evaluate mutual funds. Today, investing clients'
hard-earned cash in mutual funds requires an extra level of due
diligence. You need to protect the client as well as yourself against
charges of irresponsible investment advice.
There are two primary sources of information on fund
fiduciary ratings: Fiduciary Analytics, Sewickley, Pa., and Morningstar
Inc., Chicago.
Fiduciary Analytics just released the fifth
quarterly report on its trademarked "Mutual Fund Family Fiduciary
Rankings" in September 2004. It has been rating fund families quarterly
using Morningstar data for more than one year, based on quantitative
measures. The report is available at www.fi360.com.
The fund family rankings are based on the company's
proprietary technology, which assigns a "Fiduciary Score" for
individual mutual funds.
The individual fund's rankings are based on ten criteria, which include
management and organizational stability, risk and performance, and
one-year, three-year and five-year performance relative to peers.
Morningstar's system, launched in October, rates
individual funds. To compare, advisors must calculate the average
rating of a fund group's funds on their own.
Unlike Fiduciary Analytics, Morningstar's new
ratings exclude performance criteria. Instead, they look at qualitative
measures, such as an investment company's commitment to fund
shareholders based on the quality of the fund's board of directors. It
evaluates the fund company's corporate culture, regulatory compliance,
the number of funds overseen by fund company directors and the
relationship between the directors and the fund company. Also evaluated
are the performance of trustees, based on how they look after
shareholder interests, fund manager incentives and fund expenses.
Morningstar gives individual funds fiduciary grades,
ranging from A (the best) to F (the worst) on its monthly mutual fund
report. Financial advisors who use Morningstar's information must also
use other reports that track fund performance and risk-adjusted returns
to get the complete picture.
Morningstar examines each investment company to determine if it has run
afoul of regulators in the past three years. It also examines
Securities and Exchange Commission allegations and the company's
subsequent reforms. Senior fund analyst Chris Traulsen says Morningstar
uses three factors to determine the severity of regulatory problem: the
nature of the wrongdoing, the harm and cost to shareholders and the
command structure's role in permitting the violation to occur.
Fraudulent activity, for example, would result in a negative regulatory
score and lower fiduciary grade rating, he said. By
contrast, a minor violation would result in a slight nick to a fund's
regulatory score.
"The grades (fiduciary ratings) are not meant to be
used in isolation or as simplistic buy and sell signals," explains
Christine Benz, Morningstar Mutual Funds associate director of fund
analytics. "They represent yet another valuable addition to our suite
of investment research and tools."
Donald B. Trone, president of Fiduciary Analytics, agrees. "Advisors
are cautioned to use both (Fiduciary Analytics and Morningstar) and
never rely on a single ranking," he says
So how do fund family fiduciary ratings relate to
fund performance? Traulsen says that it's too early to tell.
Morningstar has rated only about one-third of its more than 2,000
funds. It could be several months before Morningstar can analyze the
relationship between fiduciary ratings and fund performance. However,
he thinks that poor fund performance will be a reflection of a fund
group's attitude toward its shareholders.
"My gut feel is that funds with high fees and ineffective boards of
directors will carry low fiduciary ratings," Traulsen says. "Corporate
culture and fund manager turnover are a factor."
Fiduciary Analytics' Trone says responsible fund
management should be linked with performance. "The fiduciary process
has been shown to go hand-in-hand with good performance," Trone says.
"Discipline and rigor in following a defined investment process has
always been shown to pay high dividends."
Fiduciary ratings, however, are not foolproof.
Evaluating a company's ethics and integrity involve subjective judgment
calls.
For example, Fidelity Investments' mutual funds, on average, carry a "B" fiduciary rating by Morningstar, according to Traulsen. Fidelity, along with Vanguard, American Funds and T. Rowe Price, sailed through the 2003 mutual fund scandal unscarred by any arrangements to give late trading privileges to hedge funds in return for sticky assets.
Fidelity got a "B" because the board quality was regarded as good, not excellent, and some directors served on the boards of too many funds. Additionally, Morningstar gave their manager incentives a below-average rating. In the past, the mutual fund giant has sparred with Morningstar over various disclosure issues, including proxy voting. Recently, the SEC has been investigating whether Fidelity Investments and several other fund companies directed trades to brokerage firms that gave the company excessive gifts. At this writing, no charges have been filed.
A Fidelity spokesperson says that the investment company has procedures in place regarding the acceptance of gifts. Traulsen says that if the SEC slapped Fidelity with an enforcement action, Morningstar would re-evaluate Fidelity's fiduciary ratings.
Moving down the rating spectrum, Morningstar gives Janus Funds a "C," which would appear to reflect both its role in the recent scandals and its attempt to address its problems. In contrast Strong Funds-once led by industry bad boy Dick Strong, a billionaire who earned an alleged $600,000 by violating the terms of the firm's prospectuses and was subsequently banned from the business-got an F.