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October 11, 2004
Morningstar Grades Mutual Fund Governance, SRI Funds Rate Well
    by William Baue

Morningstar Fiduciary Grades find relatively few areas of weak performance for those socially responsible investment mutual funds rated.

Just as corporate governance ratings were a logical anodyne to the recent accounting and governance scandals in the corporate world, so too are such ratings a logical antidote to the recent mutual fund scandals. In August 2004, just before mutual funds had to disclose information on the proxy voting records and regulations, the fund-rating firm Morningstar launched its Fiduciary Grade system of governance rating.

Morningstar, best known for its starred ratings of mutual fund financial performance, has assigned governance grades ranging from A (best) to F (worst) for 761 of the largest funds in the US thus far, with plans to grade 2,000 funds in all in the near future. It also has gone a step deeper by assigning ratings ranging from excellent to very poor with accompanying commentary for each fund in five governance areas: regulatory issues, board quality, manager incentives, fees, and corporate culture.

"Our analysts have long considered these less-tangible factors in an effort to help investors determine which fund companies do the best job of safeguarding their interests," said Kunal Kapoor, director of mutual fund analysis for Morningstar. "We've included this type of information in our written analyst commentaries for years, and now we're taking the next step and presenting our research in a format that will make it easier for investors to compare funds' corporate governance track records and identify the firms that embody the industry's best practices."

Socially responsible investment (SRI) mutual funds fared well in the Morningstar ratings. Of the nine broadly-screened SRI funds rated, the group as a whole received 24 excellent ratings, 11 good ratings, four fair, three poor, and three very poor.

The Ariel Fund (ticker: ARGFX) and the Ariel Appreciation Fund (CAAPX) led the pack, both receiving A grades overall.

"Ariel Funds has a corporate culture that other fund families could learn from," the rating states. "At the heart of this approach is the firm's commitment to its slow-and-steady approach, which is inculcated in every employee . . . [t]his is an important attribute because it limits any pressure to change course midway through a streak of underperformance, such as in the late 1990s.

"The firm also does right by its shareholders on many accounts," the rating continues. "For instance, shareholder reports are forthright and well written; [firm founder John] Rogers is also candid about mistakes, when appropriate."

Both Ariel funds earned excellent ratings in all categories except fees, where Morningstar rated them fair.

The Neuberger Berman Socially Responsive Fund (NBSRX) received a C grade, with an excellent rating in regulatory issues, good ratings in board quality and corporate culture, but very poor ratings in manager incentives and fees.

"This fund is a bit more expensive than the typical retail, no-load large-blend offering as well as the average no-load SRI offering that focuses on large caps and is available to retail investors," the rating states.

Peter Sundman, president of Neuberger Berman Management, considers some of Morningstar's governance rating methodology flawed. For example, he points out that the fund's expense ratio is lower than its peers, both in the total market and in the SRI market.

"An expense ratio of 1.06, and heading south as fund assets continue to grow, certainly isn't 'very poor,'" Mr. Sundman told

According to the Social Investment Forum (SIF), the average expense ratio for large blend funds in the total market is more than 1.20 percent, while the average expense ratio for SRI large blend funds is more than 1.30 percent. Higher fees typically cover the cost of social research for SRI funds.

The remaining broadly-screened SRI funds all received B grades. These funds include Calvert Social Equity (CSIEX), Calvert Tax-Free Reserve Limited Term (CTFLX), Domini Social Equity (DSEFX), Pax World Balanced (PAXWX), TIAA-CREF Social Choice Equity (TCSCX), and Vanguard Calvert Social Index (VCSIX).

Neuberger Berman was not the only firm to question Morningstar's ratings; the Calvert rating also reveals a potential limitation of Morningstar's grading system. Morningstar gave a poor rating to the Calvert Social Equity Fund in the fees category, based on the following reasoning:

"One issue is the fund's overall management fee, as well as the fee that subadvisor Atlanta Capital Management receives," the rating states. "In absolute terms, neither one is excessive."

"However, in both cases, the fees are not slated to decline as assets increase, no matter how large the fund grows," the rating continues. "Given that asset managers typically enjoy significant economies of scale as the pool of money they run increases, we think Calvert, as well as the fund's board, should consider the addition of breakpoints to both fee schedules."

In fact, Calvert did add breakpoints to the investment advisory fee, according to a supplement to the fund's prospectus dated July 12, 2004, well before the launch of the rating system but perhaps after the rating had been performed on this fund.

"Please note that a breakpoint has been added to the investment advisory fee for the CSIF Equity Portfolio," the supplement states. "Under the Investment Advisory Agreement, the Advisor receives an annual fee, payable monthly, of . . . 0.50 percent of the first $2 billion of the Equity Portfolio's average daily net assets, 0.475 percent of the next $1 billion of such assets, and 0.45 percent of all assets above $3 billion."

Morningstar also rated six more narrowly-screened SRI funds rated, such as those that exclude only tobacco and alcohol. As a group, they did not fare quite as well in the ratings as the more broadly-screened SRI funds, receiving 10 excellent ratings, four good ratings, 15 fair ratings, and one very poor rating.

The Bridgeway Ultra-Small Company Market Fund (BRSIX) earned an A and the American Fund (AMRMX) a B. Three Pioneer funds (PIODX , PIOTX, PEQIX) earned Cs, and the Smith Barney Social Awareness Fund (SSIAX) earned a D.


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