Stewardship Grades
Morningstar’s Stewardship Grades for funds go beyond the usual analysis of strategy, risk, and return. The Fiduciary Grade allows investors and advisors to assess funds based on factors that we believe influence the following:
The manner in which funds are run;
The degree to which the management company’s and fund board’s interests are aligned with fund shareholders;
The degree to which shareholders can expect their interests to be protected from potentially conflicting interests of the management company.
We assign each fund a letter grade from A (best) to F (worst). Funds are graded on an absolute basis. There is no “curve.”
Morningstar analysts' evaluation of five factors determine the grade for each fund:
Regulatory Issues
Board Quality
Manager Incentives
Fees
Corporate Culture
Each factor is worth a maximum of two points, for a total of 10 possible points. Points for each component are awarded in increments as small as 0.5 point. With the exception of Regulatory Issues, the worst possible score a fund can receive in each component is zero. For Regulatory Issues, the minimum score possible is –2.
We assign each fund's overall letter grade as follows:
A: 9 - 10 points
B: 7 - 8.5 points
C: 5 - 6.5 points
D: 3 - 4.5 points
F: 2.5 points or less
For ease of use, we translate funds' scores for each of the five individual factors into the following qualitative terms on Morningstar.com:
Excellent = 2 points
Good = 1.5 points
Fair = 1 point
Poor = 0.5 point
Very Poor = 0 points and below
Morningstar's Stewardship Grade for funds is entirely different from the Morningstar Rating for funds, commonly known as the star rating. There is no relationship between the two.
Regulatory Issues
We examine any regulatory issues at the fund company in the past three years. Serious breaches of fiduciary duty can result in a score of –2; funds with no regulatory concerns receive 2 points. In the event of any breaches, we examine the remedies in place and the scope of and commitment to reform.
Board Quality
We assess the quality of a fund’s board, looking at the following factors, each worth 0.5 point:
Has the board taken action in cases where the fund clearly hasn’t served investors well?
Do the independent directors have meaningful investments in the fund? To earn the maximum score here, at least 75% of a board's independent directors must have more money invested in the funds they oversee than they receive in aggregate annual compensation for serving on the board. However, the SEC only requires directors to report investments in dollar ranges culminating in a maximum of "more than $100,000." Thus, directors with more than $100,000 invested in the funds they oversee will be assumed to have met the above criterion.
Is the board overseeing so many funds that its ability to diligently protect the interests of the shareholders at this specific fund could be compromised?
Does the fund meet the maximum SEC requirement for the proportion of independent directors, regardless of whether or not it is subject to the requirement? (Former fund company employees, family members, and current or former employees of fund service providers are not considered independent.)
Manager Incentives
We assess two distinct components:
Fund ownership: Does the manager have significant investment in the funds he or she oversees, defined as 1/3 of his or her liquid net worth? If the funds run by the manager are inappropriate for such a large investment, does he or she have at least 1/3 of his or her liquid net worth in other funds at the same firm?
Compensation structure: We prefer compensation plans that reward long-term performance and do not emphasize asset growth. Incentive programs that encourage a focus on short-term performance or asset growth receive are viewed less favorably.
Fees
Is the fund’s expense ratio below the average for its type of share class within its Morningstar category?
Has the fund’s expense ratio declined meaningfully as assets have grown?
Corporate Culture
This component looks at a wide range of factors in an attempt to gauge how seriously a firm takes its fiduciary duty to fundholders. Morningstar analysts may consider the following factors, among others:
Has the firm launched “trendy” funds in attempt to gather assets?
Has the firm closed funds at an appropriate size, or has it allowed fund assets to grow too large?
Does the firm implement redemption fees or otherwise discourage rapid trading of its funds?
Has the firm done a good job of retaining key personnel?
How strong are the firm’s shareholder communications?
Does the firm direct fund brokerage in exchange for shelf space or use soft dollars?