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Portfolio > Asset Managers

Separate But Not Equal

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Morningstar Inc., familiar to independent advisors for its software analyzing mutual funds, has some work to do before its new separate accounts database is taken seriously. That’s the opinion of several advisors we asked to install the software and give it a run.

“It will need to be drastically improved to be considered an institutional level product,” says Scott Brewster, a CFP licensee who works at Glowacki Framson Financial Advisors in Los Angeles.

“It’s weak at best,” says Clark Blackman of Post Oak Capital Advisors in Houston.

“There are many shortcomings in the software when compared to both its sister Principia database and to its competition,” says Matt Crutchmer of Universal Advisory Services in Albuquerque.

But before giving you the detailed evaluation of this separate account add-on to Principia, it’s best to examine the broader picture of what has been happening at Morningstar. The company has been re-inventing itself in recent years. While it has long been a favorite among more sophisticated independent financial advisors, in the last few years Morningstar has been trying to capitalize on its good name and expand its reach.

The Chicago-based firm, which Joe Mansueto started in his apartment in 1984, raised $91 million in July 1999 from Softbank, intent on expanding its Internet presence. Its retail Web site, which Morningstar spokeswoman Martha Conlon Moss says has about 100,000 subscribers paying about $109 a year, is often cited as a top personal finance portal for individual investors, and its mutual fund performance data is made available to consumers through hundreds of newspapers and Web sites. The company has 600 employees in the U.S. and 300 more in its Japanese, Austra-lian, and European offices.

Its Principia core product, with its mutual fund, stock, and variable annuity databases, and its research, analysis, and reputation for integrity, has made Morningstar a favorite among fee-only financial planners and RIAs as well as financial journalists. However, Morningstar has faced significant challenges in the advisor market.

For years it has run a distant second in terms of professional users to a mutual fund software product called Investment View. Formerly known as HySales and owned by Thomson Financial, Investment View historically has been more of a selling tool for brokers, and has been sold to wirehouses, insurers, banks, and B/Ds for use by their entire field forces.

Morningstar, which until recently focused on the fragmented independent advisor business, trailed in selling to the enterprise market. For Morningstar, that is where the most growth is now–with large brokerages, banks, and insurance companies with captive brokers and agents, or with independent reps tied by the home office to proprietary technology platforms.

Use of the Internet–and growing acceptance of software applications hosted on the Web–has given Morningstar a way to grow its business in selling its data, research, and analytical applications to large enterprises with national sales forces. That is the strategic linchpin of selling its Web-based product, Advisor Workstation.

Workstation is a suite of investment analytical tools that is integrated with Morningstar’s mutual fund database. An advisor can give a client a risk tolerance questionnaire, perform a Monte Carlo simulation on the client’s asset mix, and pick mutual funds–all using one tool. Morningstar also has incorporated stock, exchange-traded funds, and variable annuity databases into Workstation. The new separate account manager database is a part of this grand scheme.

Put another way, Morningstar over the past three years has moved from being a company whose main professional customer was the sophisticated independent advisor, specifically the fee-only planner, to become a company whose primary target advisor is the registered rep. If you look at the company’s press releases this year, versus 2001, 2000, and 1999, this pattern emerges clearly, with recent press releases about deals with Nationwide Retirement Solutions, Scudder Investments, Aegon, and Merrill Lynch.

With this strategic business backdrop, the release of a weak separate accounts management product is a bit disconcerting. Advisors should be happy that Morningstar is actively pursuing more sales-oriented professionals to grow its business because that can help lower prices for independent advisors if Morningstar can increase market share, and it will strengthen its products. However, if expanding its market means that the products will be dumbed down, it’s a bit scary.

I believe the release of this unimpressive separate accounts application was a fluke. After all, I reviewed Workstation with several advisors late last year and the consensus was that it would become a strong product for professionals. Still, independent advisors should be aware of the competitive forces reshaping Morningstar’s business, and keep track of the company’s progress in continuing to meet the needs of independent advisors while it becomes a company aiming also to please captive agents and brokers.

At my request, Morningstar sent Principia for Separate Accounts to five advisors I selected. Three of the advisors loaded the program and used it, and they were unanimous in their criticism. The other two did not complete their reviews in time for this story.

The most pointed remarks came from Blackman, a modest but educated CPA/PFS, CFA, CFP, and CIMA whose firm, Post Oak Advisors, manages $500 million, two-thirds of which is placed in separate accounts. Blackman said that only 31% of the 29 managers his firm uses were tracked in the database. To see if that low coverage rate was a persistent problem, he checked coverage of Schwab’s Managed Account Select product and found only eight of the 21 managers were covered. He then found that just six of the 16 managers on SEI’s separate account platform were included in the Morningstar database.

In fairness to Morningstar, the product covers only 500 managers and 1,800 products so far, and a Morningstar press release says the company plans to have the database cover 1,000 managers and 4,500 products. Chris Boruff, who runs Morningstar’s advisor division, says there is a good reason to launch a product with a less-than-complete database. He said managers were refusing to give Morningstar their data because the company had no product yet. “Having something in the market incents more managers to participate in the database,” he argues.

Blackman says consultants will find Morningstar’s style classifications crude. For instance, it does not show you a manager’s style three years ago or five years ago, so you cannot tell if the manager has drifted from his style. The database also does not give you an information ratio, which is the annualized excess return above a benchmark to tracking error, a number that Blackman says is crucial in judging a manager.

The Devil’s in the Details

CFP licensee Scott Brewster said the database only offers you a quartile ranking for the current year, and does not give you a picture of how well a manager stacked up versus his peers over three- or five-year periods. He also found details about products missing. For instance, the fact that a manager he uses offers tax-management was not mentioned in the section of the software where this information should have been found.

“Only 666 (38%) of the accounts have returns data for 10 years, and only 1,087 (62%) have data for five years,” said Crutchmer. “This shortfall of financial data does not lend itself to accurate statistical analysis by an advisor.”

Boruff notes that this is only the first launch of this product, and that it will be improved. He says that Morningstar’s research found that its competition has been including many separate account products that have been discontinued and thus artificially inflate the size of their databases. Advisors are going to be asked what data points they want included in upcoming revisions of the database over the next year.

Comparing Principia’s separate account database to institutional systems, such as M-Search from Mobius or EFFRON from Plan Sponsor Network, is unfair, says Boruff. The Morningstar product costs $1,995 a year but has a $795 introductory price, a fraction of the price of its competitors’ products.

“Our goal is to make this an advisor tool,” says Boruff. “Mobius and EFFRON tend to be consultant- and institutional-level tools, and are more expensive, and we’ve discounted greatly from our list price. People will see differences between us and these more expensive programs but you need to keep the relative cost in mind.”

“The goal clearly is not to dumb down products,” adds Boruff. “But there is a question of whether a majority of advisors want a $10,000 product with tons of data or something that is more reasonably priced that on the whole does what they need. Ultimately, we will have a separate account product that is more expensive, and one for institutional-type investors; some advisors may be willing to pay the high price, but we don’t think that is the vast majority of advisors, even among the independents and high-end RIAs.”

As Morningstar expands its reach beyond its core niche of fee-based financial planners and RIAs and aims to attract brokers, insurance agents selling securities, and other less sophisticated investment professionals, we can only wait and see how it can continue to meet the needs of the advisors who have brought it so far. As for its separate account offering, Morningstar’s a great company that’s delivered in the past. Over the next year or two, it could well end up delivering a very good database for tracking separate account managers at a lower cost than the competition.


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