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Danger & Opportunity: Raising the Bar

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If you were asked to nominate a single representative who personifies reason and insight when it comes to investing, combined with integrity and a career-long commitment to disclosure and transparency when it comes to investing vehicles, no one could argue if you named Don Phillips.

Phillips joined Morningstar in 1986 as its first mutual fund analyst, became editor of Morningstar Mutual Funds, helped develop the ubiquitous Morningstar Style Box and Morningstar Rating, became a managing director of the company in 2000, and has served on its board since 1999.

Earlier this year, Morningstar named Phillips president of fund research, and said it was revising the way it analyzed mutual funds. At the time, Phillips was quoted as saying the change would be a “bigger picture, top-down approach to go along with the bottom-up work we’ve traditionally done.”

IA’s Washington Bureau Chief spoke with Phillips by telephone in early April about the renewed importance of research in investing.

Considering the markets and economic crisis we’ve been struggling with, is investment research, particularly on mutual funds, more important than it ever has been? I do think that due diligence on funds is more important than ever, particularly on fixed income funds. One of my colleagues said something very insightful, that stock funds stayed stock funds but bond funds have become hedge funds. You think about it, it’s in part from all of the new securities, all of the new derivatives, all of the things that are available to fixed income managers and also the pressure that’s on fixed income managers to stretch for yield.

Bond funds, sadly, are still sold largely on the basis of yield, which often causes managers to take risks that you may [give you] some small incremental gain but at some disproportionate amount of risk. We saw that last year with certain fixed income categories where the category average might have been down 20% but you had individual funds that were down more than 70%, and others that were flat–all within the same category.

So I think that a lot of the things that financial advisors have been calling for in recent years in terms of more disclosure and more information on funds, that’s all been extremely helpful and the industry has been very responsive. Nowhere around the world do you have better transparency and lower fees than you do in the U.S. fund industry, and I think that’s directly attributable to the financial services industry that has stood up for shareholders and demanded this. It’s to the industry’s credit that it has responded.

I think we have a disclosure regime now and a level of transparency that works fine if you’re dealing with blue chip stock funds or funds that are investing in more conventional, mainstream securities.

I’m not sure that the disclosure that we have–the four snapshots per year of a fund’s portfolio–is anywhere near adequate to understand what can happen on the fixed-income part of a client’s portfolio.

Do you see that changing? I think a lot of things are going to have to happen. It’s been the main focus on our team–we have a bond task force, we spend a lot of time tearing apart the portfolios that we do have, and took at performance numbers to see if there’s something that jumps out, or is abnormal, about this fund. If you look at the Reserve Fund that broke the buck, they had by far and away the highest yield of any money market fund. That’s a red flag.

There are new rules for money market funds. Clearly the industry was scared by the G30 recommendations that Paul Volcker headed up that talked about possibly making money market funds quasi bank-like entities, so the industry has come back with a very good set of proposals to raise the standards for money market funds. Clearly there has been established in the public’s mind that this is interchangeable with cash.

The industry has a responsibility to the public and itself, because it’s the industry that’s footed the bill for most of the mistakes in the money market arena. There are a lot more funds that would have broken the buck if they didn’t have to pony up money internally to make their funds whole. I think that will largely take care of itself.

I’m more worried about the long-term bond funds when firms make big mistakes, like Schwab did with Yield Plus, or Oppenheimer did with several of their funds, the fund firm moves on and the investors will be permanently scarred. Yield Plus was sold to the public as an alternative to a money market fund–aggressively sold that way. Schwab brokers were calling people up saying switch your money into this, it’s a better place for your cash than a money market fund, and it went down 38%.

The problems at Reserve pale next to that. The fund went down 38% last summer. We’re trying to get much more proactive, and clearly advisors are going to want to do that. To me that’s the big danger spot on the horizon. With equities, with the risk they are assuming…it’s a pretty good bet that a financial advisor can look at an equity fund and get a sense of what risk is in it.

I think the money market area is going to be cleaned up and the industry will adopt higher standards and there will be fewer…you won’t have major issues in money market funds.

But I think the fixed income arena is going to be a place where a lot of fundamental research is required to help people make smart decisions. I also think it’s going to be the focus of more investors. In the wake of this horrible bear market we’ve been in, I think you’re going to see a real mind shift on the part of investors and that there will be much less appetite for taking risk. There will be much more of a focus on the income part of total return as opposed to the appreciation part.

Financial advisors, when they are building portfolios for clients, are going to stress the income stream that they can create for them as opposed to long-term promises of total return and capital appreciation.

I think it’s two-fold. One is people have been hurt, burned by the risk taking of the last two years, so there’s less appetite. The other thing is that you have the baby boom generation getting older and they will be thinking more about retirement and thinking not in the same fashion about retirement…much more of ‘Boy, if I could just get more income to supplement what I might have from my retirement plans and Social Security. And can I just plot out a course for surviving retirement,’ as opposed to the pie-in-the-sky dreams people have had much of the past 10 years.

Will you be using your new position to provide some clarity or guidance in the danger zone of fixed income? I hope so. My position isn’t completely new. I’ve been in charge of the core research team and I’ve been involved with the work that John Rekenthaler and Tom Kaplan have been doing on that team for the last eight years. What’s different is that now the qualitative reports to me as well, and that’s all the fund analysts. I’ve been involved on the…side and coming up with tools, but the analysts were reporting to a different manager.

In a previous conversation you said you wanted the analysts to be more in touch with the advisors. Absolutely. I think advisors are mission critical to the investment experience in this country. The majority of individuals make their investing decisions through an advisor. Advisors shape portfolios and they are the most informed intelligence out there. How can you be thinking about what’s happening in the investment world without having a steady dialogue with the advisor community?

How do you see financial services reform affecting the mutual fund arena? I’m optimistic for financial services in general. I know these are dark days for the financial services industry, but we’re still coming out of an environment that was very hostile to investors.

The sort of old brokerage model, where firms had a gun dealer’s mentality–’We can make these products and what harm they do out there in main street America isn’t our responsibility.’

I think we’re going to a long-term transformation, moving away from that model of salesmanship, towards one of stewardship. In my mind it was the independent advisors that put this stake in the ground and said this model has to change. Over the last 20 years, they’ve transformed the business and a lot of people came over to this more client-first point of view.

Clearly, the industry as a whole isn’t there yet. I think that the turbulence over the last few months will accelerate that even more.

So do you foresee brokers being held to a fiduciary standard of care this year? I think the time has come for that. If you tried to explain to someone on the street that ‘Hey, [the person] you are paying money to help with your investments doesn’t have any responsibility for trying to get you good results.’ They’d scratch their heads and say, ‘Huh?’ It’s fascinating to hear Mary Schapiro saying more positive things about this. I think this is an idea whose time has come.

Mary Schapiro has talked of harmonizing broker and advisor rules. What do you think about that? I don’t spend a lot of time [looking at this]. But at the end of the day you have to create something that investors believe in.

There are always times when people make a lot of money in financial services demonstrating their low standards. But in the long term, what wins are those who take the high road. I think that’s why the fund industry has won. That’s also why the independent advisor model has won, because they’ve embraced a higher standard.

Trying to turn back the clock where you can just have a pure sales mentality doesn’t cut it anymore.


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