Stewardship: common sense not controversial

By Dan Hallett, CFA, CFP on July 5th, 2010

Morningstar Canada recently introduced its Stewardship Grades for 27 Canadian fund companies.  Media coverage began slowly but picked up momentum.  The Toronto Star’s Jim Daw had some valid critique of the scoring scale.  Then, Tom Bradley devoted his Globe and Mail column to the topic.  (Note:  Bradley’s Steadyhand Investment Funds ranked 8 out of 8 on Morningstar’s stewardship scale – the only perfect score of the more than two dozen surveyed firms.)

This story took an interesting twist when the Financial Post’s Jonathan Chevreau reported on his blog that the Investment Funds Institute of Canada (IFIC) attempted to block Morningstar from publishing their findings (which drew a response from Morningstar Canada CEO Scott Mackenzie).  Chevreau later wrote a related article for the paper.  There is a lot to this issue but I’ll zero in on a few items.

Industry lobbying

I have no illusions about IFIC’s raison d’être.  While they provide some helpful information for consumers, IFIC is an industry trade group that lobbies on behalf of its members – sponsors of mutual fund firms and the dealers that sell mutual funds.  Sometimes the interests of its members align with those of retail investors and sometimes they don’t.  Two decades ago they lobbied to classify trailer fees as commissions so that they would not be subject to GST.

They have spoken out on the recent HST implementation on the grounds that it unfairly taxes mutual funds compared to other investment and deposit products.  Their members have launched many products that appear aimed more at gathering assets than to further investors’ wealth accumulation.  I know all of this.  Yet, I was a bit surprised to learn of IFIC’s letter to Morningstar’s Chicago-based director of research in an effort to fight the release of Canadian stewardship grades.

Perhaps the argument I found most puzzling was the part where IFIC charges that Morningstar is “attempting to impose a new regulatory standard in place of the existing robust regulatory set of standards currently active in Canada” – and concluding that the new Stewardship Grades have no predictive value in an attempt to persuade Morningstar to sit on the study.  While Morningstar may be considered a competitor to HighView on some level, I fully support their efforts at making stewardship information available to the public temporarily and, later, to their paying clients.

You have to admire the irony in this story, however.  Fearing a media parade would follow the release of the stewardship grades, IFIC attempted to block their release.  In fact, the media was very quiet about the whole thing at first.  And a key factor fueling the story is IFIC’s surprising tactic.

The meaning and importance of stewardship

Stewardship is often confused with compliance.  As some of my partners have explained, compliance is about doing things right whereas stewardship is about doing the right thing.  The concept of stewardship is woven into everything HighView does, which is why our CEO, Mark Barnicutt, authored a paper entitled Return of the Investment Steward at the height of the credit crisis in late 2008.  A year later, in December 2009, it drove the spirit of our Chairman’s letter on our homepage.  It’s also the name of this blog, The Wealth Steward.  And we use fiduciary (the word and the concept) when describing who we are and what we do.

Stewardship is a simple concept – put clients’ interests ahead of our own – and it’s the obligation of fiduciaries.  All fund companies are fiduciaries because they have discretion over their end clients’ assets.  So, if those firms are legally held to be fiduciaries, there’s nothing extraordinary about holding them to that standard as part of the research process.

For more than a decade, I’ve been asking money managers about how they invest their personal net worth and how their bonus is calculated.  My partners at HighView have done the same – and this is a standard line of questioning that we continue to ask.  We’ve always asked several questions and monitored business decisions and marketing materials aimed at evaluating company culture.

Any worthwhile analyst asks these as part of his/her basic due diligence process.  And no serious money management firm worth talking to will refuse to answer these questions.  Inquiring about competing interests and company policies is not akin to setting a new regulatory standard – as IFIC suggests – but prudent due diligence that our clients (and, in turn, our clients’ clients) appreciate and perhaps expect.

Critiquing the work of others is much easier than actually doing the work or coming up with solutions.  There are weaknesses to any method (which I touch on below) but attempting to discredit the entire effort on that basis is misguided in my view.  If IFIC really wants a better solution for the industry, they’ll make suggestions on how to improve the stewardship grading methodology.

Limitations of stewardship grades

Overall, I think Morningstar has done a good job on the method and execution of their stewardship grades.  I note, also, that Morningstar Canada was a client of mine many years ago and I have a lot of respect for the people at 1 Toronto Street.  In that context, I have thought of a couple of questions or limitations that are worth highlighting.

One issue that stood out for me was the regulatory component of the grades.  A fund company can lose as many as two points (on their eight-point scale) due to the existence of any regulatory problems over the previous seven years.  I highlight the time frame because Morningstar’s stewardship grades seemingly missed the regulatory issue of the decade for mutual funds.  Remember the market timing scandal?

While the market timing activity ended around mid-2003 (just seven years ago), settlement payments for this activity were agreed to in December 2004.  Fund companies that settled were AGF, AIC (now part of Manulife), CI, Investors Group and Franklin Templeton.  Broker/dealers that settled were subsidiaries of BMO, RBC, TD and Investors Group.  And in one or two of those brokerage settlements the related fund company involved was not one of the five settling fund companies.  And it’s clear that at least a couple of fund companies and/or dealers (in addition to this list) were involved in market timing.

In the course of our research we’ve uncovered a fund company – one that received a good culture grade and had no regulatory deductions – that purchased shares in a related company in one of its funds.  Since the firm has followed all of the rules, technically, it’s not considered a regulatory issue.  Accordingly, the trade was not reviewed by the IRC.  But when we discovered all of the facts, we have zero doubt that a conflict of interest existed, whether or not the law defines it as such.

(Only our paying clients will learn the identity of this organization later this summer as we decide how this impacts our opinion of the firm.)

Yet this is an issue, understandably, that the stewardship grades missed because it required a fair bit of digging to uncover and pursue the issue.  To be fair, we won’t uncover every issue and there will be things that we miss.  But these are two significant instances that should illustrate that every method has its limitations.

Accordingly, advisors and investors should make use of the stewardship grades since they contain useful information – and they’re free for the summer.  But use them as a screen and in conjunction with your own due diligence and knowledge of the various fund companies.  If nothing else, getting you to think like a fiduciary and holding the firms with which you entrust client money to a fiduciary standard can only benefit your practice.