Amid research that mutual funds with good Morningstar stewardship grades tend to outperform funds with poor Stewardship grades, Morningstar has toughened those grades. Morningstar has just released new stewardship grades for more than 1,000 funds and plans to add to the coverage in the ensuing months.

Morningstar is not changing the basic structure of the stewardship grade. Fund analysts still will subjectively assign a grade to a fund by evaluating corporate culture, board quality, fees, manager incentives and regulatory history. But changes will be made to the underlying criteria used to evaluate the categories.

Whereas corporate culture used to drive 20% of the grade, this has been upped to 40% because Morningstar said corporate culture sets the tone for its other components.

In order to receive full credit in the board category, funds must have an independent chairmen and 75% independent directors. Instead of evaluating board members' workloads, more emphasis is given to how well the board oversees its funds.

Rather than assess fee trends, Morningstar now grades funds solely on their current expense ratios and how those fees compare with peers. Funds in the cheapest quintile of their peer groups receive an A in this section, and funds that are more expensive than 60% of peers receive Fs.

Firms with poor regulatory histories lose points. They no longer get points simply for following the law.

"The Stewardship Grades have been a catalyst for positive change in the fund industry," said Laura Pavlenko Lutton, senior Morningstar mutual fund analyst and head of the stewardship grade committee. "We're constantly evaluating our methodologies and felt it was a good time to revisit our grades and better recognize firms that do more than just obey the law and follow industry norms."

Under Morningstar's stewardship rating system, a mutual fund can earn a maximum of 10 points. Scores for corporate culture range from zero to four, while board quality, manager incentives, fees and regulatory history all range from zero to two.

Funds with a total of nine to 10 points are rated A. Funds with seven to 8.5 points are rated B. Funds with five to 6.5 points are rated C. Funds with three to 4.5 points are rated D. Funds with 2.5 or fewer points are rated F. Descriptive terms, like "Excellent" or "Fair," no longer are used.

Last April, a Social Science Research Network-published working paper indicated funds receiving good Morningstar stewardship grades outperformed funds with bad grades by 19 to 23 basis points per month. The study, by Jay W. Wellman, Cornell University visiting assistant professor of finance, and Jian Zhou, of the State University of New York at Binghamton, evaluated funds from January 2001 to July 2004. The researchers said that of the five variables Morningstar uses to compute the grades, the board quality and fee categories seem to most explain the difference.

Preliminary research by Northeastern University researchers David P. Boyd and Mustafa Yilmaz in late 2006 also indicated stewardship grades are a statistically significant component in effecting stock fund returns. The Boyd and Yilmaz study looked at the correlation between stewardship grades and the performance of 1,124 mutual funds. The researchers examined 860 stock funds and 264 bond fund returns over three years ending in 2005, using a regression model. The results of their statistically significant analysis showed that a one-point increase in the stewardship rating of 1,164 stock and bond funds would result in an 80-basis-point increase in the annual average return of a fund.

The study also found that stewardship is a slightly greater contribution factor in the returns of growth and value stock funds compared with blended funds. Stewardship is not a significant variable in explaining the return on bond funds because equity funds exhibit greater variability in returns than bond funds.

Past research on pension fund performance and corporate governance supports the recent relationship between fund performance and stewardship grades. Pension funds' fiduciary guidelines were quantified and related to performance in a study by Keith Ambachtsheer, Ronald Capelle and Tom Scheibelhut. The report, published in the Financial Analysts Journal's November/December 1998 issue, analyzed the returns on 50 pension funds from 1993 through 1996. The researchers found higher performance in pension funds that improved their organizational structures, decision-making processes, resources and clarity of goals.

Of the 1,000 funds graded under the new stewardship grade methodology, only two funds received perfect scores-Clipper and Selected American Shares D. Only 6% scored As, 24% got Bs, 47% got Cs, 20% got Ds and 3% scored Fs.

Stewardship grades differ from Morningstar's star ratings, which are a quantitative assessment of a fund's past risk/reward profile. By contrast, the Stewardship ratings are a fund analyst's subject assessment of a fund's commitment to shareholders' best interests.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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