By definition, intangibles cannot be measured, but that's exactly what Morningstar's recently launched Fiduciary Grade system is attempting. Last week, the Chicago-based fund research and ratings firm unveiled its newest offering, which assigns a letter grade to more than 600 funds assessing how well a fund company's, and its manager's, interests are aligned with those of shareholders. Morningstar plans to extend this rating to an additional 1,500 funds.

The newest rating system, which is available to premium members of Morningstar's Web site, is separate from the firm's signature Star rating system. Instead of using hard data, funds are rated on five, primarily subjective, categories: regulatory issues, board quality, manager incentives, fees and corporate culture. Each category is weighted equally and worth up to two points. The five categories, when added together, can total a maximum score of 10. A fund's combined tally is then translated into a letter grade of either A, B, C, D or F. For all categories, with the exception of regulatory issues, a fund can score no lower than a zero. Should Morningstar analysts deem a fund's advisor has seriously breached its fiduciary duty, they can give a grade as low as negative two.

Of the 633 funds ranked so far, more than half, or 341 funds, received a B, followed by 137 funds getting a C and 68 funds scraping by with a D. Sixty-four funds merited the top grade of A, and 23 were slapped with a failing F.

The ratings are derived from information culled from public filings, Morningstar research and responses to a survey the firm sent to fund shops. However, not all firms were willing to surrender information they deemed proprietary or inappropriate to reveal, particularly manager compensation, a point of controversy for the past several months. "Morningstar set up a potential problem by asking for information they knew was sensitive. Not getting it basically taints their evaluation," said Roy Weitz, industry critic and publisher of www.fundalarm.com. "It makes their whole process look arbitrary, [without] integrity."

Morningstar asked funds if their manager holds a significant investment, defined as one-third of their liquid net worth, in the fund. If the investment is inappropriate for the manager, Morningstar asked whether the manager holds one-third of their liquid net worth in other funds at the firm.

Additionally, Morningstar asked about compensation structure to see if management's and investors' interests are aligned. Whether compensation is based on long-term or short-term performance is also a determinant. Furthermore, Morningstar looks into whether asset growth is a factor in compensation.

American Funds, Fidelity, Smith Barney, Strong, T. Rowe Price and William Blair, among others, all had issues responding to questions relating to the manager incentives portion of the survey. In fact, both Dreyfus and Vanguard were rated "very poor" in this category, the worst possible score.

Vanguard wouldn't provide details of its compensation structure, which Morningstar described as "particularly disappointing, considering the firm's shareholder-friendly, transparent heritage." As a result, Morningstar gave all of Vanguard's funds a B rating--which Weitz thinks will raise red flags. "People are going to say, Vanguard isn't a B, no matter what's going on,' and it taints the whole system," he said.

Fidelity was given only partial credit in this section since it also withheld compensation information. Of the 83 Fidelity funds ranked by Morningstar, three received a C rating and the rest a B. Fidelity was labeled "excellent" in the categories rating fees and regulations, grabbing the maximum points allowed. It also received a "good" label, the second-best rank, for the quality of its board and its corporate culture. However, its shortcoming was in the manager incentives category, for which it received a mark of "poor," the second-lowest possible mark.

"Fidelity has refused to divulge much specific information about the structure of its fund manager compensation," Morningstar wrote in its assessment of one of Fidelity's funds. Morningstar noted that it did not ask for dollar amounts, just the factors, including weightings, used to determine a manager's bonus.

The problem with this methodology, critics say, is that the scores in this one section are often a reflection of a firm's cooperation with Morningstar, as opposed to an assessment of their actual compensation structure. In many cases, like that of Vanguard and Fidelity, there are many unknowns, which could be either good or bad. Had Fidelity and Vanguard provided the information, for instance, a number of their funds could have been rated A.

"We provided information, but I guess not as much as they wanted," said Anne Crowley, a Fidelity spokeswoman. "We did not provide details on a couple of the questions they wanted about liquid net worth related to portfolio managers. We respect the privacy and confidentiality of our managers, and we don't talk about employees' personal business." However, Crowley said the firm did provide information about the compensation structure for its portfolio managers and that it made clear to Morningstar that performance plays an important role, as opposed to a fund's benchmark and peers.

The survey was completed prior to the passage of increased disclosure requirements by the Securities and Exchange Commission earlier this month. Crowley said the firm will comply with the new law but does not have any plans to provide additional information directly to Morningstar in an attempt to change the rating. "They did give us one of their highest grades. They said many very complimentary things about Fidelity and recognized many of our strengths."

While several fund firms wouldn't comment on the possible impact or their opinion of the new system publicly, other industry observers had reservations about Morningstar's latest ratings foray. Max Rottersman, president of Fund Forensics, formerly Fund Expenses, is not a big fan. "Because this stuff is so squishy, it's impossible to quantify numerically. The right way to do this is to simply write a paragraph in your report saying what you think about the company. But because Morningstar is in the business of selling stars and ratings, they are giving them a rating because that's what they want to sell. That's good for them but bad for the investor because it gives the investor the false idea that fiduciary quality can be graded, and it cannot."

However, Weitz thinks it's "admirable" of Morningstar to try and develop such a system. "I think it's an excellent symbolic move, but I think the substance needs more work. I hope Morningstar looks at this as a start, will be open to input, and will do internal reviews on a regular basis to try and perfect the system."

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