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The Capital Advantage

PART 2
Methodology

Compiling the Fund Universe

The database built to represent the universe of both large-cap domestic and large-cap foreign funds drew from Morningstar’s U.S. Open-End Large Value, Large Blend and Large Growth U.S. and Foreign categories, with live and dead funds combined to eliminate survivorship bias. For live funds, only the oldest share class was used. For dead funds with multiple share classes, the median monthly returns were used. Investment results are shown at net asset value. If a sales charge had been deducted, results would have been lower. For fee-related illustrations that include dead funds with multiple share classes, the median expense ratios were used. This screening resulted in seven qualifying domestic American Funds (AMCAP Fund, The Growth Fund of America, The New Economy Fund, American Mutual Fund, Fundamental Investors, The Investment Company of America and Washington Mutual Investors Fund) and two qualifying foreign American Funds (EuroPacific Growth Fund and International Growth and Income Fund). Funds are identified as domestic or foreign based on Morningstar categories. A number of the U.S.-focused American Funds can invest some assets in non-U.S. securities; likewise, the two foreign-focused American Funds can invest some assets in U.S.-issued securities.

Tracking Least Expensive Quartile/Highest Manager Ownership

In conducting our research, we searched Morningstar’s database for large-cap actively managed funds that were in both the lowest quartile ranked by expense ratio and the highest quartile ranked by manager ownership at the firm level. For this analysis we relied on Morningstar Direct data analysis software.

Least expensive quartile was calculated using annual report Net Expense Ratio (NER) for all observed Morningstar categories for the 20-year period indicated. For funds with missing expense ratios, gaps between two available data points were filled in using linear interpolation. Linear interpolation is a statistical method used to estimate the values between two known data points in a time series.

Highest manager ownership quartile was calculated using weighted averages of Morningstar screens of manager holdings at the firm level. Each fund was assigned the weighted average of its firm manager holding. Funds without values were excluded from the quartile rankings.

The combination of least expensive NER and highest manager ownership quartiles (the screened equity core) was the result of a cross-section of the two screens. Only those funds with both the lowest expense ratios and the highest manager ownership were included.

Investors who wish to identify funds that ranked in the least expensive quartile by NER can rely on the following rule of thumb:

The least expensive quartile of funds ranked by net expense ratio for Class A shares roughly corresponded with those reporting expenses below 0.99% for large-cap domestic funds and below 1.10% for large-cap foreign funds. Expense ratios for institutional and advisory share classes would be approximately 25 basis points lower, or below 0.74% for large-cap domestic funds and below 0.85% for large-cap foreign funds.

Investors who wish to identify funds that ranked in the top quartile by manager ownership can rely on the following rule of thumb:

The top quartile of funds ranked by manager ownership roughly corresponded with firms that had 55% or more assets in the fund family complex in which at least one fund manager had invested a minimum of $1 million.

The Securities and Exchange Commission requires that mutual funds disclose all fees and expenses in a standardized table published in the front portion of the fund prospectus. The SEC also requires that a fund disclose in its statements of additional information (SAI) certain information about its portfolio managers, including ownership of securities in the fund. Ownership disclosure is made using the following seven ranges: none; $1 to $10,000; $10,001 to $50,000; $50,001 to $100,000; $100,001 to $500,000; $500,001 to $1,000,000; and over $1,000,000.

Morningstar tracks manager ownership as a percentage of assets at the firm level. This information can be found using Morningstar Direct software, which can be downloaded by visiting global.morningstar.com/direct and clicking on “Download Morningstar Direct.”

Advisors seeking to incorporate manager ownership as part of their fund screening criteria can take the following steps using Morningstar Direct. Start by creating a new open-end fund advanced search and defining a universe. For example, for the broad large-cap domestic fund universe, select U.S., then Large Value, Large Blend and Large Growth; to avoid duplication, screen for the oldest share class available.

With the universe selected, the snapshot page will show a set of default screens, including “Annual Report Net Expense Ratio.” It is necessary to manually add a field for manager ownership. Under Available Data Points, select “Firm % Assets Manager Investment Over $1 million.” This selection will allow you to sort the chosen fund universe by both the expense ratio and manager ownership fields.

Working With Indexes

Market indexes referenced in this material are defined as follows:

MSCI All Country World ex USA Index is a free float-adjusted market capitalization-weighted index that is designed to measure results of more than 40 developed and emerging equity markets, excluding the United States. Results reflect dividends gross of withholding taxes through December 31, 2000, and dividends net of withholding taxes thereafter.

Standard & Poor’s 500 Composite Index is a market capitalization-weighted index based on the average weighted results of 500 widely held common stocks.

The market indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. There have been periods when the funds have lagged the index. Past results are not predictive of results in future periods.