New Morningstar study shows Stewardship Grades predict success for fundholders. By Laura Pavlenko Lutton, Morningstar Editorial Director

Splashy returns and a charismatic star manager may give a mutual fund some sparkle, but a successful long-term investment is built on more than first impressions. All investors--whether they're individuals with modest nest eggs or institutions with billions on the line--want their hard-earned capital managed thoughtfully and respectfully year in and year out.

Morningstar's Stewardship Grades for mutual funds are designed to highlight which funds are likely to be good long-term partners for investors, and a new study of the grades shows it pays to be choosy. Morningstar found that most funds earning high Stewardship Grades were successful in the subsequent years. Specifically, they were very likely to survive and provide competitive risk-adjusted returns.

To determine which funds are good caretakers of capital, Morningstar's fund analysts visit fund companies, conduct extensive interviews, and comb through regulatory filings to evaluate five areas: The corporate culture of the fund's parent company; the quality of the board of directors governing the fund; the fund manager's financial incentives; the fund's fees; and the fund company's history with regulators. Each of those five areas earns a score and a letter grade, and by combining the five areas, one arrives at the fund's overall Stewardship Grade. Morningstar issues Stewardship Grades--A, B, C, D, or F--to more than 1,000 funds and updates those grades regularly.

Poor Stewards, Poor Longevity In the study out today, Morningstar looked at each of the five areas of the methodology, as well as the overall grade, to see which seemed to predict good outcomes for shareholders.

We first looked to see whether the funds graded in 2004--the year the Stewardship Grades were launched--survived to today. Funds earning top Stewardship Grades were very likely to survive--only about 1% of funds earning Stewardship Grades of A were killed off in the years that followed, while about one fourth of the D funds and one third of the F funds didn't survive. Presumably, most of the D and F funds were poor performers, as the fund industry typically doesn't kill off its top prospects.

From there, Morningstar examined how successful the funds were in the years after the Stewardship Grades were issued. We looked at the grades issued in 2004, after the initial launch, and then again in 2007, shortly after Morningstar revised its Stewardship Grade methodology. In the study, funds deemed successful were those with Morningstar Ratings of 3 or more stars, while the unsuccessful funds, as well as funds that didn't survive, were those earning 1 or 2 stars. This definition allowed us to calculate a Morningstar Rating success ratio for funds earning a particular Stewardship Grade.

Strong Stewards, Strong Risk-Adjusted Returns We found that the Morningstar Rating success ratios were significantly higher for funds earning A's and B's for the overall Stewardship Grade. More than 80% of the funds earning those top grades turned in competitive risk-adjusted returns relative to their peers.

Morningstar Rating Success Ratio by 2007 Morningstar Stewardship Grades and Components

Morningstar also looked at the Morningstar Rating success ratios of three components that make up the Stewardship Grades: corporate culture, board quality, and manager incentives. Of those three components, the funds earning A's for corporate culture stood out. To earn an A for corporate culture, a fund must hail from a firm that consistently puts its fund investors before its own profits by offering a sensible lineup of funds at fair prices. Fund firms with strong cultures also have little personnel turnover and avoid launching trendy funds that investors tend to buy and sell at inopportune times--like buying late in a rally and selling at the depths of a decline.

The funds earning an A in corporate culture were very often successful, suggesting that shareholder-friendly practices correlate with competitive risk-adjusted performance: A whopping 87% of the funds earning A's for corporate culture were successful according to the Morningstar Rating success ratio. The funds earning B's and C's for corporate culture weren't as successful as the A's, but they were more successful than funds earning failing grades for corporate culture.