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.

    Fiduciary Analytics' ratings are not considered the Holy Grail either. There are fund families with below-average Fiduciary Analytics ratings that have solid-performing stock funds, and vice versa. And Fiduciary Analytics' top-ranked firm, Baron Asset Management, was fined almost $3 million in 2003 by the SEC for violating certain trading rules, though Baron violated these rules on behalf of shareholders rather than at their expense.
   

    Trone's firm ranks 247 fund families. He says that he never has looked at the statistical correlation between fiduciary ratings and performance.

    However, based on this author's analysis of both Fiduciary Analytics and Morningstar data, there appears to be a strong relationship between the fiduciary ratings and fund family stock funds' performance. There are 161 fund families rated by Fiduciary Analytics that carried Morningstar's equity "fund family scores."

    The Morningstar "fund family score" is an asset-weighted average of a fund company's Morningstar (performance) ratings, also known as "star
ratings," within an asset class. The score can help an advisor gauge a company's overall ability within a specific asset class. The scores range from 1.0 to 5.0. A score below 2.5 is an indication that a firm has met with little success in that asset class. A score between 2.5 and 3.5 indicates the firm is about average. A score above 3.5 indicates a firm is above average.

    A word to the wise: For the relationship between fiduciary ratings and fund performance to be definitive, several years worth of data must be analyzed. Because both rating systems are new, any relationships should be consider preliminary. The shorter the analysis period, the greater the impact random chance has on the data.

    Nevertheless, this author broke into decile groups all fund families that carried both Fiduciary Analytics' ratings and Morningstar's Fund family scores for domestic stock funds. Decile group one represents the top 10% of fund families based on Fiduciary Analytics' fiduciary ratings.  The tenth decile group represents the bottom 10% of fund families.  

    The results show that the higher the Fiduciary Analytics ranking, on average, the higher the Morningstar Fund family stock fund score.

    Funds ranking in the top Fiduciary Analytics decile group (one) on average registered higher Morningstar Fund family scores than decile groups two through ten. The second and third Fiduciary Analytics decile groups also registered higher Morningstar fund family scores than the lower decile groups. But there was not much difference in scores for fund groups ranked in the bottom half of the list.  

    The number one decile group had a mean fund family score of 4.0. The second decile mean score was 3.5. The third decile group's mean score also
was 3.5. The fourth and fifth decile group each had mean scores of 3.2. The sixth and seventh decile groups each had mean scores of 3.0.

    The eighth decile group's mean score was 2.8; the ninth's mean rating was 2.7; and the tenth's mean rating was 2.6.  

    There appears to be strong correlation between the third quarter 2004 decile rankings based on Fiduciary Analytics and the average Morningstar's
equity fund family score per group. But until there is more data, it is inappropriate to conduct a correlation statistic based on normally distributed data.

    Not all mid-ranked fund families exhibit poor performance. For example, the Oakmark group of funds was in the fourth decile group based on Fiduciary's ratings. But Oakmark's stock fund Morningstar fund family score was above average at 3.6.

    The Davis Funds, based on Fiduciary Analytics' ranking, were in the fourth decile group, but its stock funds registered an above-average 4.6 Morningstar Fund family score. Meanwhile, the Thornburg fund group was ranked in Fiduciary Analytics' sixth decile group, but the Morningstar fund family score also was above average at 4.

    Fiduciary Analytics top-rated funds were not necessarily delivering superior investment returns either. For example, the USAA fund family ranked in Fiduciary Analytics' first decile group, but its funds were rated an average Morningstar Fund family score of 3. TIAA-CREF was in the second decile group based on its Fiduciary Analytics rating. However, its stock funds carried just a 2.4 Morningstar Fund family score. The RS Funds were also in the second decile group based on Fiduciary Analytics' ratings, but the Morningstar Fund family score was below average at just 2.3.

    "In the fiduciary world, the best is a slippery slope," Trone concedes.

    Fiduciary ratings, he says, are just another due diligence tool. The best-performing funds may not always have the best fiduciary ratings.

    Nevertheless, funds with top fiduciary ratings exhibit several strong characteristics that include:

    Style discipline. The fund family's mutual funds do not deviate from their stated investment style.
        Reasonable fees. Fund expense ratios are not excessive.
        Sound management. The fund managers' tenure is important, as well as the investment company's ability to garner assets.

    Trone adds that large fund families typically score well. But small fund groups that have one investment style may also score well.

    Investment companies with poor fiduciary scores characteristically have a weak organization that can't retain talent. They also have high fees, and their funds exhibit style drift.

Alan Lavine is Florida-based author of numerous investment books and contributing editor to Financial Advisor.