Morningstar is now providing Fiduciary grades on mutual funds. How are these grades determined? How can investors benefit from these grades?

Mutual funds 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 such as how seriously the mutual fund company takes its fiduciary responsibility to mutual fund investors.

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 Basics of the Morningstar Fiduciary Grade System

The Morningstar Fiduciary Grade is based on the evaluation of five areas critical for mutual fund governance and 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 action 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 mutual fund investor’s interests. 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 Mutual Funds Fiduciary Grade

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

1. Buy and Hold Investors: The first step for buy and hold mutual fund investors is to examine how mutual funds held in their portfolio stack up on the two dimensions, Morningstar Rating and Fiduciary Grade.

Mutual funds that rank favorably on both dimensions may be retained and those 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 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, these investors 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.

While total and compound annual returns are useful in analyzing mutual fund returns, discerning investors will delve deeper using a variety of metrics to get a more complete picture on mutual fund performance.

On December 16, 2005 a leading financial website reports the trailing 1-year and 5-year returns of Fidelity Contrafund (Nasdaq: FCNTX), a no-load mutual fund, as 19.01% and 6.97%, respectively. While the financial website provides useful pre-tax return information, there is more to mutual fund returns.

Is the performance of Fidelity Contrafund superior or inferior? How tax-efficient was Fidelity Contrafund in delivering these returns? Are the returns of Fidelity Contrafund commensurate with the risk its fund manager took?

Discerning mutual fund investors will want answers to such questions as they evaluate mutual fund returns. Before getting into the nitty-gritty of mutual fund returns, it is good to review what the data reported in the financial website actually mean.

Mutual Fund Total Return

Fidelity Contrafund’s reported 19.01% 1-year return is this mutual fund’s total return for the December 16, 2004 to December 15, 2005 period. In practical terms, $10,000 invested in Fidelity Contrafund on December 16, 2004, is worth $11,901 on December 15, 2005. Total return includes more than the appreciation (or depreciation) of the mutual fund’s share price. It also assumes reinvestment of all dividends as well as short- and long-term capital gain distributions into the mutual fund at the price at which the distribution is made.

Mutual Fund Compound Annual Return

The reported 5-year return of 6.97% for the Fidelity Contrafund is the mutual fund’s compound annual return. (The compound annual return is also called average annual return.) Compound annual return is a calculated number that describes the rate at which an investment has grown if it grew at a steady rate.

A $10,000 investment in Fidelity Contrafund on December 16, 2000 has grown to $14,005.87 on December 15, 2005. The ending value of $14,005.87=$10,000* [(1+0.0697)^5] where 6.97% is the compound annual return. The investment in Fidelity Contrafund grew at an implied growth rate of 6.97% over the 5-year period.

While total return and compound annual return are useful mutual fund performance metrics, they do not tell how a particular mutual fund has fared versus its peers. They also do not provide information on the return actually earned by investors after accounting for taxes. Finally, they do not offer insight on how well the mutual fund manager has managed risk while achieving the returns.

Mutual Fund Relative Return

Relative return helps in comparing the performance of a mutual fund against its peers. Relative return is the difference between the total return of a mutual fund and the total return of an appropriate benchmark over the same period.

Fidelity Contrafund is a large-cap growth mutual fund that primarily invests in U. S.-based companies. It is therefore appropriate to compare Fidelity Contra’s performance with that of other large-cap growth mutual funds. It is also appropriate to benchmark Fidelity Contra against indexes like the Standard & Poor’s 500 (S&P 500) which comprises of large U. S.-based companies.

While Fidelity Contrafund has a compound annual return of 6.97% for the 5-year period ending December 15, 2005, Morningstar reports the average large-cap growth mutual fund to have an average annual loss of 9.51%. The S&P 500 index has a compound annual return of just 0.61%. Fidelity Contrafund has outperformed both benchmarks with a relative return of 16.48% over its average large-cap growth mutual fund peer and a relative return of 6.36% over the S&P 500 index.

Mutual Fund After-Tax Return

Unlike return from assets held in qualified accounts such as 401k plans or individual retirement accounts, return from assets held in non-qualified individual or joint accounts are not tax-deferred. With non-qualified accounts, after-tax return is the return realized after accounting for taxes.

Short-term capital gains and short-term capital gain distributions received from the mutual fund are currently taxed at the same rate as earned income. Dividends, long-term capital gain distributions, and long-term capital gains realized from the sale of mutual fund shares are currently taxed at a lower rate.

Fidelity states the compound annual return for the Fidelity Contrafund before taxes is 4.01% for the trailing 5-year period ending September 30, 2005. When all distributions are taxed at the maximum possible federal tax rate, the after-tax return drops to 3.52%. The after-tax return drops further to 3.23% after accounting for the long-term capital gain tax due on sale of this mutual fund’s shares.

Mutual Fund Risk-Adjusted Return

Some mutual funds take more risk than others. It is therefore important to evaluate mutual fund returns in the light of the amount of risk mutual fund managers take to deliver the return.

Risk-adjusted return is commonly measured using the Sharpe Ratio. It is calculated using the formula (mutual fund return – risk free return)/standard deviation of mutual fund return. The higher the Sharpe Ratio, the better the fund’s return per unit-risk.

Based on returns for the 3-year period ending November 30, 2005, Morningstar reports Fidelity Contrafund’s Sharpe Ratio as 1.74. Fidelity Contrafund’s Sharpe Ratio may be compared with those of similar mutual funds to determine how Fidelity Contra’s risk-adjusted return compares with those of its peers.

Beyond Mutual Funds

Return concepts such as relative return, after-tax return, and risk-adjusted return are useful in analyzing not only mutual funds but also separately-managed accounts, hedge funds, and investment newsletter model portfolios.

The AlphaProfit Sector Investors’ Newsletter, for example, tracks the annual return and compound annual return of its Core and Focus model portfolios. To provide Subscribers with more complete picture on model portfolio returns, this investment newsletter also tracks the relative and risk-adjusted returns of the model portfolios. The investment newsletter’s model portfolios are constructed and repositioned with a view to maximizing after-tax returns.

Summary

While total return and compound annual return provide useful information on mutual fund performance, they do not provide a complete picture. Metrics such as relative return and after-tax return can provide valuable insights on a mutual fund’s relative performance and tax efficiency. By looking at risk-adjusted returns, investors can assess how a mutual fund’s returns stack up when risk is factored in.

In their quest for the best no load mutual fund, some mutual fund investors tend to select mutual funds based solely on fees and expense ratios. Is this always a good way to select mutual funds?

Metrics such as price/earnings ratio and dividend yield on the S&P 500 index, a commonly used proxy for the U.S. stock market, are hardly at bargain levels. Several market experts prognosticate single digit annual returns for domestic mutual funds over the next decade.

In pursuing the selection for the best mutual fund, some mutual fund investors tend to focus exclusively on fees and expense ratios. The rationale is that by choosing mutual funds with low fees, investors can have more of their capital invested. Also, no load mutual funds with low expense ratios will pass on more of the returns they earn to their shareholders.

Is shopping for the lowest fees and expense ratios the right way to select mutual funds? Not always. The answer depends on the type of mutual fund you are evaluating, the time you can devote to evaluating and managing your mutual funds investments, and the type of cost incurred.

Investing in the Best No Load Index Mutual Funds.

If you believe markets are generally efficient and prefer to invest in an index mutual fund to achieve an index-like return, shopping for the best index mutual fund based on low fees and a low expense ratio makes perfect sense. An index mutual fund’s portfolio manager seeks to invest the fund’s assets to track an index as closely and as cost-effectively as possible. Larger index funds have an advantage since they can spread their operating costs over a larger asset base.

Some of the interesting index mutual fund options currently available include no load index mutual funds like E*Trade S&P 500 Index Fund (Nasdaq: ETSPX), Fidelity Spartan 500 Index Fund (Nasdaq: FSMKX), and Vanguard 500 Index Fund (Nasdaq: VFINX) with expense ratios of 0.09%, 0.10%, and 0.18%, respectively.

Investing in Actively Managed Mutual Funds and Strategies.

If you believe portfolio managers can add value and out-perform the index through active management, fees and expenses are just one of several important factors to consider. The portfolio manager’s ability and investing style are just as important. Therefore, seeking out the best mutual fund based on just low fees and a low expense ratio may not always be the right approach. It may just be the case of being ‘penny-wise and pound-foolish’.

Legendary investor Peter Lynch, who managed the Fidelity Magellan Fund (Nasdaq: FMAGX) from 1977 to 1990, achieved returns well in excess of the market averages even after accounting for the fund’s fees and expenses.

So too has Bill Miller who currently manages the Legg Mason Value Trust (Nasdaq: LMVTX). Even after accounting for its relatively high 1.7% expense ratio, this no load mutual fund has achieved compound annual returns of 18.6% for the 10 year period ending in 2004, well in excess of 12.0% for the Vanguard 500 Index mutual fund.

AlphaProfit, an investment research firm that specializes in sector investing, uses the no load Fidelity Select Funds to implement its investing strategy through its Core™ and Focus™ model portfolios. Although not the lowest, the expense ratio of the no load Fidelity Select Funds compares favorably with that of other sector fund offerings. AlphaProfit prefers Fidelity Selects for their comprehensive coverage of sectors and industry groups. The AlphaProfit model portfolios have significantly outperformed the market averages over time.

Ensuring Your Mutual Fund Puts Your Interest First.

Whether you prefer to index or take an active approach to managing your investments, ensuring that your mutual fund is putting your interests first is good investing practice.

 Mutual funds charge different types of fees. By looking at some key factors pertaining to fees, you can get a sense of whether the mutual fund puts your interests first or merely seeks to line the mutual fund company’s pockets.

Serving the Interests of Long-Term Shareholders. Some mutual funds impose short-term trading fees to discourage frequent trading of mutual fund shares. Frequent trading disrupts efficient management of the mutual fund and increases operating expenses. A short-term trading fee can therefore actually be beneficial to long-term shareholders if the fee is rightly treated by the mutual fund company.

Fidelity Spartan Total Market Index Fund (Nasdaq: FSTMX), for example, follows the practice of returning short-term trading fees collected on shares held less than 90 days to the mutual fund itself rather than passing on the benefit to the mutual fund company. By having this short-term trading fee structure, this no load mutual fund seeks to contain its operating expenses. Such fees are therefore aligned with the interests of long-term shareholders of this mutual fund.

Passing on Savings from Scale Economies. The operating expenses incurred by a mutual fund are a combination of fixed and variable costs. As the assets of a mutual fund increase, the fixed cost gets spread over a larger asset base. Therefore, the expenses incurred to operate the mutual fund as a percentage of the fund’s assets should trend lower.

A mutual fund that places the interest of shareholders first must pass on the savings from scale economies to shareholders. The trend in a mutual fund’s expense ratio therefore serves as a metric of how seriously a fund takes its fiduciary responsibility.

Key Points.

• If you are searching for the best no load index mutual fund, shopping for one with low fees and expenses makes perfect sense.
• If active management of investments appeals to you, fees and expenses are just one of several important factors to consider. The ability and investing style of the portfolio manager are at least just as important as fees.
• The types of fees a mutual fund charges and how the fund uses the fees provides clues as to how seriously a mutual fund takes its fiduciary responsibility. Mutual funds that impose fees to contain operating expenses and return fees to the mutual fund help protect the interests of long-term shareholders.
• Mutual funds that put the shareholders’ interests first typically pass on savings from scale economies to the shareholders.