The Globe and Mail, Report on Business
Published June 26, 2010
There has never been more investment information available to investors, so it’s frustrating to see the release of the Morningstar Stewardship Grades, the most useful piece of research to come out in decades, slide by with little or no coverage from the major media outlets and investment bloggers.
I’m frustrated for a couple of reasons. Selfishly, I’d like to see it get more attention because I run a fund company that ranked well. But more importantly, the report opens a window into the inner workings of the asset management industry and investors should look through it. Morningstar has used its clout and research depth to reveal what insiders know, but which until now has been invisible to the outside world.
Most of the information coming at investors is data that’s readily available, easily measurable, but unfortunately, of little value. They’re barraged by economic forecasts and market projections, all of which have little impact on portfolio returns. They’re shown fund comparisons based on year-to-date and one-year performance, which are totally random and of no use to anyone.
The Morningstar research is at the opposite end of the spectrum. Stewardship, which is the degree to which mutual fund companies’ interests are aligned with their unitholders, is subjective and tough to measure, but it plays an important role in selecting an investment manager.
There are four components to the grading system – corporate culture, manager incentives, fees and regulatory history. The first two make up 75 per cent of the score (6 out of 8 points) and are the hard-to-measure stuff. With respect to culture, they attempt to answer the following questions. Does the company have a thoughtful, repeatable investment process? Does it offer clear, pertinent disclosure? Is it a responsible marketer? And the biggie, do talented managers spend much or all of their careers at the firm?
In the manager incentives category, they assess whether fund managers are invested alongside the clients and the degree to which they are rewarded for long-term returns (as opposed to asset growth and short-term numbers).
These are the same criteria that consultants and institutional investors (pension plans, endowments and corporations) consider when they’re selecting managers. Long-term performance is a necessary qualification for entering the race, but people, process, incentives and ownership structure weigh heavily in the decision.
Stewardship is important because investors are prone to making long-term decisions based on short-term inputs. Morningstar provides individual investors with much needed data that is likely to be stable over time. By bringing investment process and personnel into the equation, investors are encouraged to move away from making decisions based strictly on recent performance.
It’s also important because what we’ve been doing over the past twenty years hasn’t worked. Selling yesterday’s disappointment to buy yesterday’s glory has led to poor results. The “Cycle of Hope,” as I call it, has to be broken. To do that, investors need information that allows them to be patient and gives them some comfort that past returns can be repeated in the future.
The stewardship grades are not without their critics. For an industry that is constantly measured quantitatively (returns), this research is uncomfortably qualitative. Joanne De Laurentis, president and CEO of IFIC (Investment Funds Institute of Canada) sent a letter to Morningstar voicing “serious concerns” and asking them to not release the study. She found it to be “qualitative and subjective” and pointed out that there are different views on whether fund managers should invest in the funds they manage.
The Toronto Star’s James Daw found the eight-point scale “rough at best” and felt it exaggerated the differences between companies.
In the business of investing, no research report is perfect or guaranteed to be correct. Assessing the subjective factors that constitute stewardship is a difficult process. But this doesn’t negate its importance.
Despite the simplicity of Morningstar’s grades, the study does what it’s supposed to do. It reveals significant differences between how ‘A’ rated firms (Mawer, Beutel Goodman, Chou Funds, Capital International and Steadyhand) relate to their clients compared with the firms with ‘C’ and ‘D’ grades. The ‘A’s fees are generally lower. Their products are investment driven as opposed to being sales and marketing vehicles. They have a process and team that have been in place for a long time. And they eat their own cooking.
Ultimately, it’s up to the investor to decide how important the information is and where it fits into their decision-making process. In the meantime, I hope the Stewardship Grades get the industry and media stirred up because we need to make changes. Frequent manager turnover, high fees, and poor disclosure are not a road to mutual fund prosperity.