Mutual fund managers who invest in companies with strong corporate governance profiles produce better long-term returns.

That was the key finding of a recent research report examining the relationship between governance and performance. The joint study from Lipper and Governance Metrics International (GMI) showed that within the large-cap domestic equity fund universe, funds overweight well-governed companies have outperformed the average fund over three-year and five-year periods. Furthermore, buying into companies with quality management teams has afforded long-term holders with lower risk over time.

The two firms cross-referenced the equity holdings of 725 large-cap stock funds in Lipper's database with corporate governance ratings calculated by GMI for more than 1,000 publicly traded firms. GMI's ratings, which range from one to 10, are based on a series of criteria that includes: the makeup of the board of directors, the transparency of its financial disclosure, shareholder rights, executive compensation and the reputation of the firm. For example, a firm with specific policies in place that would impede the independent director's ability to oversee the management team would receive lower governance rating.

The Legg Mason Focus Fund, a large-cap growth offering, was assigned a weighted average holdings governance score of 5.41, the report detailed. Nearly 18% of the fund's rated holdings had "well-below average" governance ratings. The top holding within that fund as of June 30, 2003 was an Internet stock. Although the name of the stock was not named in the report, GMI noted that only a third of its directors could be classified as being independent. And less than half of the company's directors owned common stock in the company.

Another red flag was the fact that the CEO/chairman took interest-free loans from the company to pay for construction on his home and purchased an aircraft for executive and director use. The company's head also controlled more than 50% of the voting rights on its board.

Meanwhile, the Scudder Focus Value+Growth Fund, a large-cap core offering, was assigned a weighted average holdings governance score of 6.56 by GMI. One of its largest holdings was a retail stock that comprised 3% of the portfolio and held a GMI rating of one, as of May 31, 2003. Only one of its seven directors was classified as independent and its lead director was a partner in a law firm that provides services to the company. Another poor mark for the firm is the fact that only one out of its three audit committee members can be considered independent.

High Marks for Large-Cap Value

Large-cap value funds held the largest allocations to the top-rated firms, the report said. Roughly 41% of GMI's database received a rating of 7.5 or higher, which means that they qualify as having above average or well above average corporate governance. That compares with 58% of the average large-cap value fund, 55% of the average large-cap core fund and 48% of the average large-cap growth fund. Overall, value funds had flatter distribution and more poorly rated stocks than core or growth funds, according to the report.

The funds that produced the best three-year return among well-governed stock funds were the Northern Funds Large Cap Value Fund, Hennessy Total Return Fund, TD Waterhouse Dow 30 Fund, Sequoia Fund and the ING Corporate Leaders Trust Fund.

The worst of the bunch were the Janus Mercury Fund, Van Kampen Select Growth, the Gartmore Focus Fund, Jundt Twenty-Five Fund and the ASAF ProFund Managed OTC Fund.

"For all three large-cap styles (core, value and growth), the funds with the largest holdings of poorly governed firms had lower total return ratings and poorer risk ratings than those that placed their bets with better governed stocks," said Sean McLaughlin, a spokesman for New York-based Lipper, in a statement.

"Managers who shun low-rated stocks generally fared better than their counterparts who have higher holdings in tainted firms."

The study also found that having better governance did not necessarily translate into better returns over the last year, which suggests that investors need to be in for the long haul in order to reap the benefits. The better fund performance did not hold true for one-year returns, McLaughlin noted, but he said this was not surprising given the run-up in technology last year and the fact that tech stocks traditionally have sub-par governance profiles.

"This research is yet another indication of the relationship between governance practice and performance," said GMI President Gavin Anderson. "Mutual fund investors should be asking their managers to disclose the governance profile of their funds. It is an investment risk they should be made aware of."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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