Morningstar Advisor - December/January 2010 - 29

If a fund company’s culture doesn’t always put investors before profits, it’s unlikely to produce a good shareholder experience. In fact, Morningstar’s research has shown that fund firms that earn top corporate-culture grades as part of Morningstar’s Stewardship Grades for mutual funds also have been some of the biggest winners of target-date assets, suggesting that investors are choosing firms that are good stewards of capital. Data also suggests that firms with strong corporate cultures launch and merge away fewer funds. For target-date investors, choosing a series backed by a strong corporate culture makes it more likely that the series will undergo few additions and subtractions when it comes to the underlying funds. Vanguard, for example, earns an A for the corporate-culture section of its Stewardship Grades, and it has merged away just one fund since 2005 and launched two dozen funds (which is relatively low considering the firm’s size). Vanguard is careful not to launch trendy funds beyond its core competencies and, therefore, has less need to merge funds away. It has managed its target-date series with similar prudence. Board Oversight and Regulatory History Breaking It Down How two firms performed in People and Parent factors. American Funds People Factors DWS Short manager tenure Low manager retention Pay for long-term performance Low manager investment Bottom Management Manager Comp People Rating Long manager tenure High manager retention Pay for long-term performance Spotty manager investment Top Parent Factors Corporate Culture Investor focused No gimmicky funds Low fees Working to unify culture after mergers Streamlined fund lineup Talented managers have left Highly independent board Strong investment in fund shares Service to shareholders mostly good More detail and explanation than most Implicated in 2004 market-timing scandal Average Below Average Board Oversight Highly independent board Mixed investment in fund shares Service to shareholders mostly good Transparency Regulatory History Parent Rating Overall Rating Not enough detail on investment rationale No serious run-ins with regulators Above Average Top There is also insight to be gathered from measuring the funds’ governance. In assessing fund boards, Morningstar first looks for industry-leading standards for independence, specifically leadership by an independent chairman and at least 75% of the trustees as independent of the advisor. Board members are also expected to have significant investments in the funds they oversee. Lastly, there should be evidence that the board has taken concrete steps in the best interests of shareholders by negotiating lower fees, merging redundant and unsuccessful offerings, or pushing for manager changes or a subadvisory contract if a fund hasn’t been run well. Among the 20 target-date fund series that Morningstar evaluated, no boards satisfied all these best-practices criteria. Some scored highly for their independence and investments but could be doing more to serve shareholders. The Putnam fund board, for example, is run by an independent chairman and has a supermajority of independent trustees, but the board hasn’t always pushed back on trendy fund launches or sought industry-leading management teams. Meanwhile, other fund boards have produced good results for shareholders but fall short for independence or personal investments in the funds they oversee. This is the case with the Vanguard board, which is led by insider Jack Brennan, the firm’s former CEO. Nonetheless, the board has served shareholders with well-run funds sporting low fees. The target-date families’ regulatory compliance records are good overall, but there have been some noteworthy missteps. A handful of firms were involved in the early 2000s’ market-timing scandal, and a division of ING was accused of paying a New York teachers union to endorse and promote ING annuity plans. For investors choosing a caretaker for their capital, it’s not necessary to take on a series that’s run by a parent that lacks focus on what’s best for shareholders. Need for Better Disclosure The final criterion in the Parent section is based on how well the target-date series’ advisor explains these complicated investments to shareholders. Based on the current information on fund companies’ Web sites and in filings with the SEC, it’s tough—if not downright impossible—for shareholders to understand how their target-date funds were designed and how they work. Target-date series would go a long way toward helping shareholders be better owners if they were to publish transparent, easily accessible information on the rationale that lies behind their decisions on asset-allocation and manager selection. K Laura Pavlenko Lutton is an editorial director of Morningstar’s Fund Research Group. On the Web In September, Morningstar published a target-datefund industry survey. 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Morningstar Advisor - December/January 2010

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