Morningstar Mutual Funds Fiduciary Grades: What Investors Need to Know

Morningstar now provides Fiduciary Grades on mutual funds. How does Morningstar determine these grades? How can mutual fund investors use these grades to better manage their portfolios? Mutual fund investors use Morningstar Rating™ as a sign post of mutual fund performance. These ratings have proved to be a valuable tool for objectively comparing the performances of different mutual funds.

In 2003, 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 the aftermath of these developments, investors realize that they need more than the historical performance based Morningstar Ratings to evaluate mutual funds. The Morningstar Ratings do not get at critical intangibles. How seriously does the mutual fund company take its fiduciary responsibility to mutual fund investors? How aligned are the interests of the mutual fund manager and the mutual fund company with those of the mutual fund investor?

To address this need, Morningstar has embarked on a system called the Fiduciary Grade. Morningstar has so far graded about 635 mutual funds, including 500 of the largest ones. Morningstar plans to provide Fiduciary Grades for a total of 2000 mutual funds over time.

Mutual funds are rewarded for having expense ratios lower than that of their peers and for effectively reducing their expense ratios with growth in their assets.

The Morningstar Fiduciary Grade System Basics

The Morningstar Fiduciary Grade is based on the evaluation of five areas critical for mutual fund governance and mutual fund 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.

1. Regulatory Issues: Morningstar examines if 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? Unlike the other four areas, the minimum score here can be a minus 2.

2. Board Quality: Morningstar looks for a demonstrated track record of the mutual fund board 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 where 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 that of their peers and for effectively reducing their expense ratios with growth in their assets.

5. Corporate Culture: Morningstar looks for tangible evidence that the mutual fund company takes its fiduciary responsibility seriously. Among the factors Morningstar 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.

The points scored on each of the above areas are aggregated and the Fiduciary Grade is assigned based on the total: A=9-10, B=7-8.5, C=5-6.5, D=3-4.5, F=2.5 or less.

How Investors Can Use the Morningstar Fiduciary Grade

Here are some ways investors can use the Morningstar Fiduciary Grade.

1. Buy and Hold Investors: Buy and hold mutual fund investors first need to examine how mutual funds held in their portfolios stack up on the two dimensions, Morningstar Rating and Fiduciary 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 clear-cut. Retaining a fund with strong Morningstar Rating but lower Fiduciary 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 portfolio should in general have no trouble in finding mutual funds with favorable Morningstar Rating as well as Fiduciary Grade.

2. Tactical Asset Allocators: A tactical asset allocator uses an active investment strategy and typically invests in mutual funds such as sector funds. For example, AlphaProfit uses its ValuM investment process, http://www.alphaprofit.com/mutual-fund-selection.html to periodically alter the mix of its mutual fund model portfolios to take advantage of specific trends (e.g. rising natural gas prices, introduction of new wireless technologies).

Since tactical asset allocators seek superior performance during their mutual fund holding period, factors such as superior long-term performance which determine Morningstar Ratings are less important to them. However, these investors typically seek to own mutual funds within a single family such as Fidelity Investments for purposes of administrative ease. As such, tactical asset allocators will find the Fiduciary Grade useful in evaluating and choosing mutual fund families to implement their strategies.

Our Take on the Morningstar Fiduciary Grade System

The Fiduciary Grade system is a blend of several metrics. The grading of mutual funds on regulatory issues is backward looking rather than 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 board quality.

The Mutual Fund Fiduciary Grade ranking provides mutual fund investors with much needed insight on the governance and operations of mutual funds. The Morningstar Fiduciary Grade System is a good first step. We believe Morningstar will refine the Mutual Fund Fiduciary Grade system over time, just as they refined the Morningstar Ratings system.

While Morningstar Ratings do an excellent job of objectively evaluating past performance, financial markets by their very nature do not allow the investor to predict future performance based on these ratings alone. Many times, funds with Morningstar Ratings of 4- or 5-star do not live up to their expectations.

The utility of the Morningstar Fiduciary Grade will be significantly enhanced if superior Fiduciary Grade either by itself or in combination with the Morningstar Rating becomes a better indicator of superior future performance. We believe the Morningstar Fiduciary Grade has the potential to become a worthy metric of mutual fund stewardship over time.

Notes: This report is for information purposes only. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice. This report does not have regard to the specific investment objectives, financial situation, and particular needs of any specific person who may receive this report. The information contained in this report is obtained from various sources believed to be accurate and is provided without warranties of any kind. AlphaProfit Investments, LLC does not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. AlphaProfit Investments, LLC is not responsible for any errors or omissions herein. Opinions expressed herein reflect the opinion of AlphaProfit Investments, LLC and are subject to change without notice. AlphaProfit Investments, LLC disclaims any liability for any direct or incidental loss incurred by applying any of the information in this report. Morningstar Rating™ is a trademark of Morningstar, Inc. The third-party trademarks or service marks appearing within this report are the property of their respective owners. All other trademarks appearing herein are the property of AlphaProfit Investments, LLC. Owners and employees of AlphaProfit Investments, LLC for their own accounts invest in the Fidelity Mutual Funds. AlphaProfit Investments, LLC neither is associated with nor receives any compensation from Fidelity Investments. Past performance is neither an indication of nor a guarantee for future results. No part of this document may be reproduced in any manner without written permission of AlphaProfit Investments, LLC. Copyright © 2004 AlphaProfit Investments, LLC. All rights reserved..

Sam Subramanian, PhD, MBA is Managing Principal of AlphaProfit Investments, LLC. http://www.alphaprofit.com He edits the AlphaProfit Sector Investors' Newsletter™. For the 5 year period ending December 31, 2003, AlphaProfit model portfolios increased by up to 252%, a compound annual return of 28.6%. To learn more about AlphaProfit and to subscribe to the FREE newsletter, visit http://www.alphaprofit.com

 

Exchange Traded Funds: 7 Reasons They Beat Most Mutual Funds

There's been a lot of recent talk in the financial press about exchange traded funds, or ETFs. Some of you may already be familiar with them, but my guess is for most individual investors, the term "exchange traded fund" is just another bunch of financial gibberish - vaguely familiar but completely meaningless. Well, to artlessly coin a phrase from the movie Braveheart, "we'll 'ave to remedy that then, won't we."

In financial-speak, ETFs are hybrid investment vehicles that combine the trading flexibility of individual stocks with the diversification benefits of mutual funds. ETFs possess characteristics that make them particularly suited for investors who want a low-cost way to obtain broad exposure to specific sectors of the financial markets.

That's mouthful, but what it really means is that ETFs are like mutual funds, only better. And they are better for several reasons.

First, ETFs are cheaper than mutual funds. ETFs have extremely low annual expenses, often less than 20 basis points (0.2%). Contrast this with actively managed mutual funds whose disclosed expenses average over 135 basis points (1.35%) - and this doesn't even include the additional 2% to 5% in loads, 12(b)-1 marketing fees, transactions costs, and soft dollar expenses mutual funds charge you but never disclose (except in the teeny-weenie small print nobody ever reads).

Second, ETFs have a lower turnover than most mutual funds. Because ETFs are passively managed and consist of a fairly static basket of stocks, they generally have little or no portfolio turnover. Contrast this with many actively managed mutual funds that can turn their portfolio over several times during the course of a year - incurring transaction fees on each purchase and sale. Third, ETFs are more tax-efficient than mutual funds. Unlike actively managed mutual funds, which annually spin off taxable short-term gains and distributions to shareholders, ETFs ordinarily only generate taxable capital gains when you sell them. Moreover, due to their unique legal structure, ETFs are also more tax-efficient than their passively managed index mutual fund counterparts. Fourth, ETFs give you more flexibility than mutual funds. They can be bought and sold through your broker without restriction during the trading day, just like a traditional stock. This provides investors with significant flexibility compared to mutual fund investors, who cannot engage in transactions during market hours. Fifth, ETFs allow you to more easily customize your portfolio than you can with passively managed mutual funds. Today, there are over 150 ETFs sponsored by a variety of institutions, including SelectSector SPDRs (State Street Global Advisors), iShares (Barclays Global Investors), HOLDRs (Merrill Lynch), and VIPERs (Vanguard). These ETFs focus on dozens of different market sectors, from bonds to technology, and everything in between.

As a result, investors can mix and match them to achieve a desired portfolio balance, emphasizing certain sectors while staying away from others depending on the market environment. Sixth, ETFs are more cash efficient than mutual funds. Since ETFs don't need to maintain a cash position to satisfy redemptions, they can be fully invested in securities. This usually allows them to outperform a mutual fund with a corresponding basket of securities, but which incurs a substantial cash drag. Finally, ETFs offer more sophisticated hedging options for experienced investors. Because ETFs can be bought on margin or sold short like a stock, they allow experienced investors to implement sophisticated hedging, market-neutral, and other alternative investment strategies. Exchange traded funds aren't for everyone, though. Because they are traded on stock exchanges, you incur a brokerage commission when you purchase or sell them. As a result, if you are making small regular contributions to your investing account, you'll end up being swamped in commissions. For more information about exchange traded funds, you can go to ETFConnect (www.etfconnect.com) or the American Stock Exchange website (www.amex.com). Or, feel free to take a look at my recent white paper entitled Exchange Traded Funds: Investment And Hedging Strategies at (www.flagship-capital.com).

David A. Twibell is president of Flagship Capital Management, an investment advisory firm in Colorado Springs, Colorado. Flagship provides portfolio management and wealth planning services to individuals, corporations, and non-profit entities. For more information, please visit www.flagship-capital.com.

No Load Mutual Funds or Exchange Traded Funds (ETFs)? 

If you are fed up with early redemption charges and ever increasing mutual fund management fees on top of bad-performing fund managers, read on. There is a quiet revolution going on in the no-load mutual fund industry and you, the individual investor, may benefit from it greatly.

I am referring to Exchange Traded Funds (ETFs), which have been around for years, but have grown tremendously since their inception. There are currently over 100 choices with around $10 billion in assets.

In a nutshell, an ETF is a specific kind of no-load mutual fund that you might consider to be a basket of stocks. ETFs are diversified like mutual funds, only they trade like stocks. They are cheap to trade (as low as $8.00) and don't hit you with any short-term redemption fees. And they offer investing opportunities across the board.

ETFs track every index under the sun including the S&P 500, the Nasdaq 100, The Russell 2000 and many others. Available through any discount broker, they basically fall into one of three categories: broad-based U.S. indexes, sectors and international.

The have esoteric names such as iShares, StreetTracks, HOLDRs and SPYDRs. The difference is in the index they are tracking and the company marketing them. You will see big name companies offering them, like the American Stock Exchange, Barclay's Global Investors, Vanguard, and State Street Global Investors.

In my newsletter I track the currently most appropriate ETFs for you to consider. For more detailed information you can visit these web sites:

www.nasdaq.com www.amex.com www.ishares.com

In addition to inexpensive trades and no short-term redemption fees, how else can ETFs save you money vs. no load mutual funds? One way is on their annual management fees. That fee for ETFs is in the area of 0.45% vs. 1.5% on average for no load mutual funds. The fees charged by discount broker are so low they almost can be disregarded, usually less than 0.1% of the transaction.

For example, I have used ETFs for some managed account clients during my last Buy cycle, which started on 4/29/03, and paid $27 for a $28,000 order -- and that wasn't even with the cheapest discount broker.

So, if these ETFs are so great, why hasn't your broker or financial planner recommended them to you? Simple! Brokers, and those advisors working on commissions, don't make money on ETFs; no commissions up front or hidden on the back end. It's simply not in their interest to promote them.

With all the positives for the investor, there is one disadvantage, which may not be applicable to you unless you are a hot shot no load mutual fund picker. It is that in any given economic environment really super performing mutual funds can outperform the indexes, but an ETF can never outperform the index it's tied to. You would need to look at your own investment record to know whether this is a downside for you.

Here's a real life example from my advisory practice. My trend tracking indicator signaled a Buy on 4/29/03. Based on my momentum indicators I chose 5 no load mutual funds and 4 ETFs. Over the following 3 months my ETFs gained anywhere from +10.02% to +22.36%, while my no load mutual funds gained from +9.15% to +36.35%. If you're fortunate enough to make a superior selection you will outperform an ETF. Of course, that presumes you picked a very successful fund as compared to only a moderately successful ETF.

A word of caution! Just because ETFs are cheap and easy to buy doesn't mean they will guarantee you a profit. You can lose money with them just as easily as you do with no-load mutual funds. You still need to make sure you have a disciplined methodology in place to help you get into and out of the market. If you don't, you're gambling no matter what you invest in.

Having gotten the disclaimer out of the way, hopefully these insights into ETFs will broaden your perspective on ways you can prosper in your investments.

© Ulli G. Niemann

Ulli Niemann is an investment advisor and has written about methodical approaches to investing for over 10 years. He avoided the bear market of 2000 and has helped countless people make better investment decisions. Subscribe to his free newsletter: www.successful-investment.com

How (NOT) to Buy Mutual Funds

When it comes to mutual funds, there is a lot more to success than just finding a good one. Sad investment stories like the following are all too common. I hope my sharing it with you will help you avoid making the same devastating financial mistake one of my former clients made.

This story begins during the height of the investment madness in 2000, just prior to the bear market. I had been managing an IRA account for "Bob" for around six years, with a better than average record of success. So I was surprised when Bob sheepishly called in July, 2000 to let me know he was transferring his IRA account, which had done particularly well during our latest Buy cycle going into the year 2000.

However, his tax preparer, a long time personal friend of Bob's wife's, was now also offering investment services, having recently received his Registered Representative's license.

Fast forward to the end of September. It had become increasingly clear to me that the Bull market had run its course. So, in accordance with the Sell signal from our trend tracking methodology, we sold all of our mutual fund positions on October 13, 2000 and went 100% into money market. (See my article "How we eluded the Bear in 2000" at http://www.successful-investment.com/articles12.htm). From our safe haven we watched the market crash and burn, causing most other investors to sustain double digit losses eventually reaching as high as 50 - 60% of their assets.

In 2002 Bob unexpectedly stopped by my office. As it turned out, things had not gone well at all with his IRA investments. As most advisors would have done, his tax preparer/advisor had quickly moved all of Bob's assets into a variety of "load funds."

Of course, being newly licensed he was clueless (as were many licensed advisors) as to market behavior or analysis of any kind. The end result was that Bob's portfolio lost in excess of 50% over the next 2 years. (Not to gloat, but my clients' losses in the same period were non-existent.)

Unfortunately, the degree of loss Bob sustained was experienced by many investors who did not follow a disciplined and methodical approach.

What I find particularly distasteful is that Bob's tax preparer misused his position of trust. He made financial decisions that he was not qualified to make, though his license implied that he did know enough to make them. So now we know what a piece of paper is worth.

This is no different than letting a newly graduated medical student with a fresh MD behind his name perform heart surgery. Or, hiring a new MBA grad to Chief Financial Officer of a Fortune 500 company. Yet the financial services industry allows someone to get a license (after a fairly short course) and to immediately start making incredibly important and far reaching financial decisions for anyone he or she can sell their service to.

This is a worrisome trend in this industry. A CPA friend confirmed that he has been approached many times by firms wanting him to offer investment services.

Why? It's easy money! Accountants and tax professionals have a great business base. They are in a unique position of trust, because of the information their clients disclose to them. Whether they are employed by a company or they maintain an individual practice, there is probably no other person (other than your spouse) who knows as many intimate details of your financial life as your accountant ax preparer.

To abuse this trust for personal gain--no matter how noble the motive may appear--is a total conflict of interest and a huge betrayal.

The bear market of 2000 has shown that investing must be a disciplined endeavor. Even most professionals have failed to recognize this. What busy accountant, in the middle of tax season, can put the necessary time and attention to a volatile investment market that may require action at a moment's notice?

As for Bob, he's still with his accountant, and in the same investments that brought his portfolio down. He's hoping for a miracle recovery. As of this writing, the stock market is engaged in something of an upswing and Bob, I'm sure, is getting his hopes up that he will recover some of his losses. However, I shudder to think that this rally may come to an end and the bear market resumes. Where will Bob be then?

At 58 years old Bob is still playing Russian roulette with his retirement. He's apparently unable to make a decision to move to someone who has the ability to make sense of market trends and the discipline to follow the signals they communicate. This is a decision that will have a profound affect on his financial future--and will determine whether his story has a happy or sad ending.

Ulli Niemann is an investment advisor and has been writing about objective, methodical approaches to investing for over 10 years. He eluded the bear market of 2000 and has helped countless people make better investment decisions. To find out more about his approach and his FREE Newsletter, please visit: www.successful-investment.com.

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