How effective are stewardship grades?

Ashley Redmond: I'm Ashley Redmond for Morningstar.ca. We launched Stewardship Grades in 2010 to find out how investor-friendly mutual fund companies really are. It's 2014, it's four years later, and we want to know how effective Stewardship Grades have been in predicting performance. I'm joined by Director of Manager Research, Christopher Davis, who wrote a white paper on Stewardship and he's here to share some of his findings.

Christopher, thanks for joining me.

Christopher Davis: Thanks for having me, Ashley.

Redmond: So Christopher, let's start with this, what are Stewardship Grades trying to do?

Davis: Well, Stewardship Grades are trying to assess how investor-friendly a fund company is. We're looking at several different factors. We're looking at a fund company's investment culture. We're looking at whether managers invest alongside fund holders. We're looking at the level of fees that the fund companies charge and we're asking whether fund companies have gotten in any regulatory hot water in recent years.

Redmond: What were some of the main findings of the study?

Davis: It's important to understand that we don't do the stewardship grades too necessarily predict future performance. But it does stand to reason that if a fund company is run in the best interest of the fund holders, then fund holders should do well from a performance standpoint. Fortunately, that has been the case. In fact, if you look at firms with Stewardship Grades of A, which is the highest grade, they were twice as likely to outperform as fund companies who had a C Stewardship Grades. So, there is a really strong relationship between the Stewardship Grade and future performance.

Redmond: I know some companies have moved up from C to B to A. So when you look at that, would you say that the overall stewardship landscape is improving?

Davis: I think that's really the good news. Our research indicates that Canadian stewardship practices are on an upward trajectory and that's a really great thing to see. In 2010, we had one firm that [received] a D in stewardship, but that did not happen in 2013, our most recent year that we studied stewardship. And there are far fewer Cs, and a lot more Bs in stewardship. More importantly, I think around 20% of investor assets are with C stewards now, but that was 80% in 2010. So, that’s a real change for the investor experience.

Redmond: There are various factors that you look out for stewardship and one of them is manager incentive. Have you found that that field is improving at all?

Davis: Well, we've seen a lot of improvements especially with disclosure. In 2010, fund companies were very reluctant to tell us how much managers were investing in their funds or the funds offered by the entire firm. Now fund companies are much more willing to do so. There are only a handful of holdouts there. So now we can really see the extent that managers are eating their own cooking, or at least eating the cooking of their colleagues. We think that it is just common sense that managers who invest in their own funds are more apt to be more careful in taking risk because it's their own nest eggs at stake.

Redmond: One factor that a lot of retail investors are concerned about and I'm sure we're all concerned about is fees. Have you seen improvements in that area?

Davis: I think this is probably where the industry needs to improve the most. It's become cheaper to run funds over the past four years and that's because assets have grown at a lot of the biggest fund companies like Fidelity, RBC, CI, but investors really haven't benefited from this growth. Expenses are where they were four years ago. In RBC's case they've actually gotten a little bit more expensive relative to their peers. RBC still offers a relatively good deal, but given the fact that they are already the biggest investment organization in Canada and have gotten bigger, it's really benefited RBC more than the individual investors.

Redmond: So, fees is the biggest area of improvement.

Davis: Right, and the reason we're looking at fees from a stewardship standpoint is because they are a clear test as to how fund companies have balanced their own interest, which is to make a lot of money and have fees as high as possible; compare that to the interest of the investor, who wants the lowest fees with the best performance possible. Overall, high fees generally lead to relatively poor performance.

Redmond: And it seems like one of the best things that comes out of stewardship is disclosure and that benefits the investor in the end, so I'm glad to hear that disclosure is improving.

Davis: We did highlight some firms that have really top rate disclosure in the study. I'd point to Steadyhand Investments, who was just a few years old when we first released our Stewardship Grade in 2010, and they've only gotten better in terms of stewardship. For instance, you can find out how much the managers and members of the Steadyhand organization invest in Steadyhand Funds on the website. Their communication is very clear. And I think that really helps investors make good decisions.

Redmond: Great. Thanks so much Christopher.

Davis: Thanks for having me.

Redmond: This week on Morningstar.ca we will be publishing articles on Monday, Wednesday and Friday on Christopher's findings. Make sure you check the homepage of Morningstar.ca for more insight.