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Fiduciary Analytics Takes Quantitative Fund Rating Approach

Fiduciary Analytics, a Sewickley, Pa.-based research company, is taking a different tack than Morningstar of Chicago in evaluating investment company fiduciary capabilities. Fiduciary Analytics' fiduciary rankings are based on quantitative measures. By contrast, Morningstar's ratings are primarily qualitative.

Fiduciary Analytics, which released its fifth quarterly report, uses 10 criteria to rate a fund's fiduciary strength in a scoring of up to 100. These include: tenure of the portfolio manager of at least two years; low risk, as measured by an Alpha and Sharpe ratio above the peer group's median; an expense ratio below the top quartile of the most expensive funds in its category; and one-, three- and five-year performance above the median of its peers. The firm will only recommend those funds that grade in the top 25%. The report is available at

By contrast, Morningstar's new ratings system excludes performance criteria and is based on five, largely subjective, categories: regulatory issues, board quality, manager incentives, fees and corporate culture (see MME 8/30/04). Each can earn up to two points for a total of zero to 10, which is then translated into letter grades of A, B, C, D or F.

Donald B. Trone, president of Fiduciary Analytics, maintains that his system does a better job of protecting fiduciaries' exposure. "Fiduciaries, such as trustees, investment advisors and retirement plan investment committees, are required to prudently manage investment decisions," he said. "When a mutual fund family is implicated in wrongdoing, the fiduciary must show evidence that a process was followed in deciding whether a fund family should be retained. Knowing the fund family's overall fiduciary ranking can demonstrate that a prudent process was followed."

Trone said that investment fiduciaries need to know how a fund's risk and performance measures are related to other factors that his system includes, such as a track record of at least three years, assets of at least $75 million and the absence of style drift by making sure that at least 80% of a fund's holdings are consistent with those of its peer group's asset class.

These determinants do more than prove good governance, Trone said. "The fiduciary process has been shown to go hand-in-hand with good performance," he maintained. "Discipline and rigor in following a defined investment process has always been shown to pay high dividends."

Morningstar jumped into the fiduciary ratings fray in August with a ratings system looking at just over 600 funds that will be expanded to a total of 2,100. Fiduciary Analytics covers more than 14,000 mutual funds in 247 fund families. Morningstar judges an investment company's commitment to fund shareholders by looking at the quality of the fund's board of directors. It evaluates the fund company's corporate culture, regulatory compliance, the number of funds overseen by fund company directors and the relationship between the directors and the fund. Morningstar also grades trustees' performance, based on how they look after shareholder interests, as well as fund manager incentives and fund expenses.

But money managers that use Morningstar's new fiduciary ratings system must also use the research giant's other reports tracking fund performance and star ratings to get the complete picture, according to the firm. "The grades [fiduciary ratings] are not meant to be used in isolation or as simplistic buy and sell signals," said Christine Benz, associate director of fund analytics at Morningstar. "They represent yet another valuable addition to our suite of investment research and tools."

Trone agrees. He says financial advisers should use more than one tool, including his own. "Advisers are cautioned to use both [Fiduciary Analytics and Morningstar] and never rely on a single ranking."

Fiduciary Analytics' trademarked Mutual Fund Family Fiduciary Rankings provides a fiduciary score that ranks funds within their peer groups as "Passed," "Appropriate," "Watch (2)," "Watch (3)," or "Watch (4)." The fiduciary score is the percentile rank of a mutual fund's raw score relative to its peer group based upon fields of data. Funds with less than three years of history are not considered. A fiduciary score of "0" is most favorable, while a score of "100" is least favorable.

Trone says that top-rated fund families exhibit several strong characteristics that include:

* Style discipline. The fund family's mutual funds do not deviate from their stated investment style.

* Reasonable fees. Fund expense ratios are not excessive.

* Sound management. The fund managers' tenure is important, as well as the investment company's ability to garner assets.

Typically, Trone adds that large fund families score well. But small fund groups that have one investment style may also score well. Investment companies with poor fiduciary scores characteristically have a weak organization that can't retain talent. They also have high fees and their funds exhibit style drift.

The top five fund families with the best fiduciary scores in Fiduciary Analytics' rating at press time include: Baron Asset Funds, Matthews Asian Funds, Rainier Investment Funds, Vanguard Group and Hotchkis and Wiley.