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Fund Spy
The standards that we expect funds to meet
Want some guides on how to pick funds? Morningstar uses this set of values. Theyre good for you, too.
By Kunal Kapoor, Morningstar
We've always been advocates of looking beyond performance when assessing mutual funds. It's the most widely available piece of information, but far from the only factor investors should consider if they want to make wise investment decisions.
After all, chasing performance is the single biggest mistake investors make. More important than past returns are such issues as the soundness of the fund manager's strategy, whether the manager's incentives are aligned with those of shareholders, and how much investors are paying for their investments.
Looking beyond fund performance
What follows is a list of Morningstar values that guide our analysts in their research. These are the guideposts we use to look beyond performance and assess the true investment merits of a fund. When deciding whether to include a fund on our Analyst Picks list, our Analyst Pans list, or whether to recommend the fund at all depends on how well it measures up based on these principles. (Our fund star ratings, by contrast, are purely quantitative; these values don't directly influence them.)
These values have been implicit in the way we've analyzed funds ever since Morningstar was founded in 1984. We like to see, for example, managers whose incentives are tied to the long-term performance of their funds, not measures such as asset growth.
We're crystallizing these values here because, as the ongoing fund scandal has highlighted, fund managers and fund companies have in many cases failed miserably in their roles as fiduciaries--and therefore run afoul of these core values.
A fund's investment strategy must be fundamentally sound.
A fund's strategy must make investment sense for long-term investors. We will not recommend gimmicky funds or those in narrow market segments such as the Internet.
- Experience: We expect mutual funds to have experienced portfolio managers, and the quality of management experience is a key consideration for our recommendations. We will only recommend managers with demonstrated investing acumen in their strategy and at least five years of experience managing money.
- Returns: We expect every fund to disclose whether it aims to maximize pre- or after-tax returns.
- Redemption fees: Funds should have redemption fees to discourage disruptive short-term trading, and should take steps to ensure that their net asset values accurately reflect the current value of their underlying holdings.
Costs must be reasonable and fully disclosed.
We will not recommend funds with high expenses.
- A class shares: Long-term investors in load funds are generally better off in A class shares. We are especially skeptical of B shares without a conversion feature.
- Merger fees: Fund company mergers should not result in an increase in fees.
- Management fees: Fees for a firm's retail products should not be materially different from management fees for a firm's institutional offerings. Though we appreciate the added costs of servicing smaller accounts, those expenses needn't show up in the management fees.
- Expense ratios: We disagree with the premise that specialized fund strategies should result in higher expense ratios. Though we will make accommodations to reflect the higher costs inherent in running a smaller fund, we don't think funds of the same size ought to be charging materially different expenses.
Investors are entitled to complete disclosure.
That includes a fund's strategy and investment team as well as costs.
- Managers: Funds must disclose the names and the backgrounds of their managers.
- Strategy: Changes in strategy and manager duties should be disclosed promptly and completely.
- Performance: We expect managers to provide forthright commentary on their funds' positioning and performance.
At the time of a fund company merger, we expect full disclosure on whether the manager, strategy, and expenses will remain the same. We also expect disclosure of the duration of contracts signed by portfolio managers at the time of a merger or acquisition, with additional details about any opt-out clauses.
No hidden interest
The interests of investment managers, board members, and fund company executives must be aligned with those of fund shareholders.
- Investment participation: We expect significant manager and executive participation (via investments) in their funds.
- Compensation disclosure: We expect disclosure of manager and executive compensation, particularly as it pertains to calculating bonuses. We favor incentives based on maximizing long-term risk-adjusted returns for fund shareholders, not for the stockholders of the management company.
- Payment in shares: Fund directors should be paid in -- and required to hold -- fund shares.
Finally, fund boards must replace consistently poor-performing investment managers.
Copyright 2003. Morningstar, Inc. All rights reserved.
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