Danger & Opportunity: Raising the Bar

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.