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
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
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.
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).
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:
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
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
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.