Mutual Funds: Morningstar Ratings & Fiduciary Grades
Morningstar now provides Fiduciary Grades on mutual funds. How can investors use Morningstar Ratings and Fiduciary Grades to better manage their portfolios?
by Sam Subramanian
Mutual fund investors use Morningstar Rating™ as a sign post of mutual fund performance. Morningstar 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.
The Morningstar Mutual Funds 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
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 Mutual Funds Fiduciary Gradee
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
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
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 Mutual Funds 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 Morningstar 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 a
pplying 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.