Bogleheads on Investing- Episode 025 transcript

Don Phillips

Don Phillips is the former CEO and a managing director of Morningstar, Inc. who remains involved in corporate strategy and investment research. He joined Morningstar in 1986 as the company’s first mutual fund analyst and soon became editor of its flagship publication, Morningstar Mutual Funds™, establishing the editorial voice for which the company is best known. Don helped to develop the Morningstar® Style Box™, the Morningstar® Rating™, and other innovations that have become industry standards.

Investment Advisor magazine named him as one of the most influential people in the financial industry in 2006, and Financial Planning magazine named Phillips one of the planning industry’s “Movers & Shakers” in 2003. Don holds a bachelor’s degree in English from the University of Texas and a master’s degree in American literature from the University of Chicago.

Episode 025- guest Don Phillips

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Rick Ferri, August 30, 2020

Rick Ferri: Welcome to Bogleheads on Investing podcast number 25. Today my special guest is Don Phillips, former CEO and a managing director of Morningstar. Over the last 35 years Don has had a front seat watching and commenting on the many changes that have occurred in the mutual fund and advisor industries.

Hi everyone. My name is Rick Ferri and I’m the host of Bogleheads on Investing. This podcast, as with all podcasts, is brought to you by  the John C. Bogle Center for FInancial Literacy, a 501c3 non-profit organization that can be found at bogelcenter.net. Today our special guest is Don Phillips.  Don is a former CEO of Morningstar and a managing director who remains involved with corporate strategy and investment research. Don joined Morningstar in 1986 as the company’s first mutual fund analyst and soon became the editor of its flagship publication, Morningstar Mutual Funds. He established an editorial voice for the company and under his leadership the company developed Morningstar style boxes, the Morningstar rating system and many analysis techniques that are staple in the mutual fund industry today.

This podcast is a fast-moving discussion about many topics of interest in the mutual fund, ETF and advisor industries and we even touch on Federal Reserve policy and cyber securities. So fasten your seat belts, here we go. I’m delighted to have with us today Don Phillips. Welcome to the podcast Don.

Don Phillips: Thank you, Rick.

Rick Ferri: Don, you have quite an interesting history. You joined Morningstar back in 1986 as the first mutual fund analyst and ironically I was just getting into the business around that time. Can you tell us a little bit about your background?

Don Phillips: I had started investing back when I was a teenager. My dad bought me 100 shares of the Templeton Growth Fund for Christmas one year and then he sat me down on Friday night when Wall Street Week with Louis Rukeyser was on and John Templeton was the guest host.  And I was just so impressed. It’s like here I am this little paper boy and here’s my personal money manager on national television. And it just really was amazing to me. It just sort of opened up a world for me, and for a long time I thought of Templeton as a role model. And I think it was only later in life that I realized that the real role model was my father. He was showing me that investing was something that he did as a responsible adult and it was something that I could do. So I had an early  introduction to funds and really thought it was a sensible way to invest.

I studied economics at college and completed all my coursework in economics, but then switched over to English literature and was pursuing a master’s degree in literature at the University of Chicago when I decided to sort of flip things around. I was thinking that I’d become a college professor but be an active investor on the side. And I decided to flip that around and say, “Well, why don’t I get a job writing about researching investments, hopefully mutual funds and then read the great books on the side?” And Joe Mansueto ran an ad in the Chicago Tribune that said: wanted mutual fund writer; and I sent him an impassioned letter saying this is exactly what I want to do with my career. We came in and talked for an hour about John Templeton, and two days later he called up and offered me the job.

Rick Ferri: Now if I recall a story about Joe doing mutual fund analysis at the kitchen, at his kitchen table.

Don Phillips:  Yeah, I joined Morningstar after Joe had moved out of the apartment. So I never had to deal with the dirty socks on the floor, things like that. He was in the Monadnock Building in Chicago, had just sort of moved in there. But he had started the company in ‘84, so it’d been around for about eighteen months to two years before I joined, and he was already putting out the Mutual Fund SourceBook, which had a tremendous amount of mutual fund data in it. It had holdings. It only covered equity funds. He wasn’t quite sure how he was going to cover bond funds at the time and it didn’t have any analysis of the individual funds, but it did have the star rating. 

That predates me, but I was hired for a second publication that Joe wanted to do and it’s the one that you were probably more familiar with. And it had the one page reviews of funds. It had a lot of data and graphs. And I was hired to write that text, to sort of interpret the data, to call up fund managers to get additional information, and to give an investor kind of a fuller picture of what they needed to know about that fund, to decide if it was appropriate for them or not.

Rick Ferri: I recall the first job I had in the industry. I was working at Kidder Peabody and we used to begin to get these paper editions of Morningstar printed on newspaper type print and they were fascinating to go through them, there was such great information. Eventually this continued to grow and at one point along the way you got to meet Jack Bogle. Can you talk about your relationship with Jack?

Joe Phillips: Well Jack became an early and ardent supporter of Morningstar and he was talking about us in the press before I ever met him. I remember one early quote, he said something along the lines of “I bow to no man in my respect for Morningstar,” and I think what he realized early on is that we were coming at investing from the same point of view that he did, and that we believed if the investor doesn’t win in the long run everyone else in the process has failed. It all has to be about investor success and helping people meet their goals. It’s not just about, you know, making a lot of profits for the asset management company or for the person selling the funds. It’s about the investor.

And I think Jack also realized that we were shining a light on the playing field and that the more it became a clear well-lit, even playing field the more the cost advantages that he had at Vanguard and the superior investment product would win out over time. So he was a big early supporter of ours and I always appreciated that. But it’s simply because we had philosophically the same mindset about doing what’s right for investors.

Rick Ferri: So you had to review all these active funds. That was your first job and write about them and really get into the nitty gritty detail. I mean you were truly a mutual fund analyst and you know probably one of the first ones out there.  But you eventually started to have an affinity for index funds. Can you talk about how that “aha” moment occurred.

Don Phillips: Well I don’t know that it was an ”aha” moment.  We were always just looking for things that are good for investors and index funds clearly were good for investors. It’s broad-based diversification, low-cost, and I should back up and say maybe what Jack Bogle would call a traditional index fund is good for investors. Later on we saw some bad behavior under the index tent and at one point there were you know scores of index funds that had turnover ratios of more than 100 percent a year, or expense ratios of more than one percent a year, and as Jack Bogle would say, that the whole case for indexing falls apart if it’s not prefaced by the words, low cost and low turnover, it was broad market indexing.

But indexing just became more and more compelling, interestingly, as active management became better and that’s sort of the paradoxical part about it. You know, for one segment of the market players to better the averages you’ve got to have some other group of participants who are underperforming. And for years those underperforming participants that allowed active managers to be above average were the individual investors or the shoot from the hip stock brokers who were advising individual investors. And these individual investors going out trying to play the market, you often times had very poor results. And you may recall back then they used to talk about this thing they called the odd lot theory. That meant when the volume of small trades, odd lots being buying securities in less than 100 share blocks, when the volume of that went up it meant that individual investors were piling in the market and that was a sign of a market top.

And so for a long time you did get superior performance among active managers because you had this underperforming group of individuals. But what happened over time is those individuals got smarter. They said, “Hey we’re tired of being the suckers here. We’re not going to buy individual stocks. We’re going to start buying funds.” And so now all of a sudden it was only professionals who were really dominating the market. But even in the early days you still had a lot of mutual funds, active managers, who regularly outperformed the market, and it seems to me you can’t prove this, but where that advantage went away was when regulation Fair Disclosure went out and no longer did the big East Coast shops get first crack at corporate management, or maybe get little insights. Once it came out that corporations had to give information out to all participants at the same time that sort of structural advantage and superior performance that you saw from some big East Coast shops year after year after year started to go away.

And then you also saw as more money went into mutual funds is that, across the board, the caliber of the asset management went up. And I think the CFA program had a huge amount to do with this, and that it started educating more people. Analysts even at small fund shops became very sophisticated and much better at what they were doing, and more importantly maybe they were also being trained in the same methodology.

And so now all of a sudden when you’ve got the market dominated by professionals who have access to the same information and are using the same mindset to analyze securities, active management became more and more homogeneous. And in my mind that’s what really set up the stage for the rise of passive investing. Because passive investing is simply about keeping your costs down. Keeping your transaction costs down. Keeping your expense ratios down. And when you’re looking at a homogeneous group, it’s the low cost provider that’s going to be the winner there. And so the great irony is that passive has succeeded largely because active got better.

Rick Ferri: As I went through the CFA  program, and it’s true that it was very good program and it produced a lot of good analysts and money managers who were all basically kind of doing it the same way.

Don Philips: But, you know, before you had really big shops which had training programs and their analysts all became maybe the equivalents of today’s CFAs. But then you had a lot of mom-and-pop shops and people forget what a cottage industry the fund industry was. You know twenty, thirty years ago there were all of these small shops and maybe their main stock picker, maybe someone just with drawing out little hand charts and going to the newspaper every day and writing down prices and then trying to do head and shoulder diagrams or something like that and it was not nearly as sophisticated an industry thirty years ago that it is today. And it was as the industry grew in sophistication and became more homogeneous that the case for indexing became even more compelling because it was harder to find consistently superior managers, because that pocket of underperformers started to be chipped away at.

Rick Ferri: Interesting that you talk about the odd lot trend line and such, where the number of odd lots going up, therefore more speculators in the market, that it signals in some way a market top, I recall the number of day traders in the 1990s, who you ran into them and they were quitting their day job to become day traders. We were all saying this has got to be near a market top.

Well now, I know it’s funny, but you know what I mean, I’m seeing that right now. Right now you’ve got these Robinhood traders. You’ve got people who I see on twitter who just are absolutely convinced that they can outperform the market. As I see the same thing that I saw back in the 1990s, the same attitudes. Maybe a different group of people, you know, a different generation. But it’s the same thing and so we have the rise of the day traders if you will,  supposedly using a more sophisticated technology or whatever but you know could this possibly be a signal that we’re reaching a long-term market top? I don’t know.

Don Phillips: Those are questions well worth asking me and you know the nice thing though is that you do see oftentimes termed as the behavior gap, you know the difference between the time weighted returns and the dollar weighted returns. It’s starting to really shrink and I think a big reason it’s shrinking is that more investors, or higher percentage of investors are becoming buy and hold index investors, or they’re using more sophisticated longer-term asset allocation plans as opposed to market timing and trying to jump in and out of the market. And the more you just buy and hold the market the more you’re going to enhance your returns over time and the more you’re going to get rid of that behavior gap because if you just buy and hold you know your dollar weighted return becomes essentially the same as your time weighted return over time.

So I think we are seeing on the whole, through things like 401k plans, the great success of independent advisors out there helping people make better investment decisions, we’re seeing, on the whole, I think, massive improvement in the average investor’s experience.

Rick Ferri: Your comments about the investor gap shrinking, the performance gap. Your own data at Morningstar shows that people who have been in balanced funds and target date funds or LifeStrategy funds where the rebalancing is done automatically for them is actually a positive performance gap. 

Don Phillips: Yeah, I mean you could actually use the bad investor behavior of others against them if you’re a bit of a contrarian. So in a balanced fund where you’re re-establishing the balance, stocks go up you sell them and you buy more bonds. You’re constantly re-establishing that balance and you’re going against the fear and greed emotions that investors have. And you know that to me is a central investment question. We know that investors are driven by fear and greed. They have this manic cycle, and I think the question all of us in and around the asset management industry have to ask ourselves is are we going to be a part of accelerating that fear and greed cycle, out promoting hot products at their peaks and then, you know, yelling run for the hills at the at the troughs. Or are we going to be a part of trying to calm down that cycle and help investors ride this out. And the nice thing is that things as you mentioned, like balanced funds or target date funds, and anyone working with it, with a good financial advisor, is going to get a sophisticated balanced portfolio based on good strong asset allocation principles today, all of which are much more likely to lead to a better result. It’s certainly better than calling up your broker thirty years ago and saying,”Hey what’s this week’s hot tip?”

Rick Ferri: Well l look at advised client portfolios every day as my business. Now I’m doing an hourly business and so I don’t have any skin in the game anymore. I’m not managing money but I do get to look at portfolios every day and many of them are from advisors, and yes, there’s a subset that does it right, but there’s also a subset that is all over the place.

Don Phillips: That’s a very fair point. You know I wrote a commentary once called The Third Rail. The thing that no one in and around financial services wants to say and that’s that lots of people like to say look how much the average investor underperforms the broad market. But the thing that they never throw in is that the average investor today is using an advisor. Because most individuals use some kind of advice, or they use for something in like a 401k plan where there’s someone who has a fiduciary responsibility. And so if you put those two things together, that the average investor is doing poorly and the average investor is working with an advisor, it means that there must be an awful lot of bad advice out there.

And at one point there was more bad advice than good, I would argue. If you turn back the days when the wirehouses’ sort of their mutual funds were the biggest in the industry and they were some of the worst performers. But increasingly today assets flow to the better funds and increasingly people are deploying them more successfully and they’re holding them for longer periods. They’re not just trying to jump in and out. And so I tend to be an optimist and say on the whole things are trending in the right direction. But I would agree with you wholeheartedly and say that we’re not at that point where everyone’s having a great experience and that there aren’t still bad actors out there. 

Rick Ferri: You know a lot of times we point to fees as the reason why active management underperforms indexing and then we can look at fees for active management coming down pretty substantially over the past twenty years. The fees for indexing and index funds and passive, the traditional ones that you spoke about, are also coming down. But the irony is of the data that I look at, even though active management fees have come down quite a bit and traditional index fees have come down some, they were already low to begin with, and they came down some more. The number of active managers that are underperforming the indexes is still the same amount, it hasn’t come down. So there’s something else going on there, and I think the fact is active management is just getting tougher and tougher and tougher. As you  pointed to earlier with the quality of active managers that are out there.

Don Philips: It’s absolutely true. Another thing is that it’s been the biggest companies that just keep getting bigger and bigger that are what is driving the market. You know look what’s happened with the FAANG stocks recently and you think about this. You know an active manager might easily have a three times the market weight in a small cap stock, but they’re never going to have three times the market weight in Amazon. You’d have to, you know, put a double digit amount of your portfolio into that one stock, and no one ever does that. And so active management tends to do better on a relative basis in small cap led markets than they do in large cap led, and certainly you know those kind of markets, this is an environment where we’ve been in the last two decades where the biggest keep getting bigger, is one that is not advantageous to active management.

And active management, as you point out, doesn’t need that disadvantage because it’s already at a crippling disadvantage due to cost, especially if you think of, if you include taxes in cost. Which can just completely decimate the case for active management when you take into account the tax consequences of their actions. 

Rick Ferri: This is a really good segue into style boxes because you mentioned that the average active manager more equal weights their portfolio than market weights their portfolio. Therefore they are going to have a higher probability of having more weight towards mid cap and small cap individual names than say the market would. However years ago you created Morningstar style boxes which captured this and put these managers in the right boxes, or at least attempted to put the active managers as closely as you could into the right boxes. To try to give you a more apples to apples comparison. So tell us about the whole evolution of the style boxes.

Don Phillips: Well it came from attending a financial planners conference and advisors were sitting around the table saying, ”How do I explain to my client why we have more than one US equity fund in their portfolio?” They said, ”The client would say, you know look, we’ve already got this one equity fund. Why do we need another general equity fund. Let’s add a gold fund or let’s add a sector technology fund.”  And the advisors were saying, “Gee I could see adding a gold fund or a tech fund but that should be the seventh or eighth fund we add, not the second. How do we explain to an investor that two US equity funds might be complementary to each other, and another two might be overlapping and that the two I’m suggesting actually complement each other and aren’t doing the same thing, and so it’s actually bringing diversification.”

And what we really want to do is give the investor control over the analysis of their funds and back then some of our rivals in the fund tracking business, they basically just let fund companies pick their category. If they called it a growth and income fund it went into the growth and income category. And yet their definition of growth and income might be very different from someone else’s, and we wanted to police that to a certain extent. And we also wanted to get rid of what I call sort of the inside baseball talk. I mean back then you had to be an insider to know that Windsor meant large cap value stocks. That was John Neff’s strategy. And that Janus meant large cap growth. If you were an insider and you knew those things were great but there was nothing about the name Windsor or Janus that gave you a clue how they were going to invest that money.

And what we wanted to do is just create more apples to apples comparison so an investor could understand it, could make better comparisons between funds and could understand perhaps what role in the portfolio, or what part of the economy, or the economic opportunities a certain manager was mining in, and to set more realistic expectations. You know, to expect Windsor to outperform in a growth led market would be foolish. And yet if you didn’t have that understanding that Windsor really bought value-oriented stocks, and it had headwinds and tailwinds that were different than Janus you would end up consistently selling Windsor at the time you should be adding to it. And buying Janus at the time you should be selling it. So we just wanted it to be descriptive and to help people and advisors get on the same page and better understand and set more reasonable expectations for the funds that they were holding.

Rick Ferri: About this time, 1994, Gene Fama and Ken French came out with their cross section of returns paper which talked about the three factor model, beta, size, value which was measured by them by book to market. How much did this influence Morningstar’s decision to go with a Morningstar style box? And how much did that work? And I know that your value is not book to market, you have a multi-factor approach to value and growth. But could you explain the academic side to it?

Don Phillips: Well initially the way we looked at value was just price to earnings and price to book. It was just those two added together. You know, the relative position and then averaged. Yeah I think it was a nice correlation. I mean obviously we were doing this before they were doing it. But it was already there, was circulating out there and you did have a handful of managers positioning themselves as small cap value and you know some as large cap growth. But most of the things that were small cap were on the growth side. There used to be a small cap category and an aggressive growth category, and they tended to have an awful lot of gray area between them.

So I  think the academic backup of this thing, that look size and style are something that has predicted value and are important differentiations, I think that maybe encouraged more fund companies to pay attention to this. And then the style box also gave sort of the unintended consequence of the style boxes, it gave fund companies a road map on what kinds of products that they could develop because right now they could say we could look at this nine box grid and say we’ve got funds that map into three of these, so now what we have to do is go out and create the other six.

And that was never our intention. We didn’t design the stylebox to be a marketing roadmap for product creation. We did it for these much more pedestrian intentions of trying to just help investors understand what a manager was doing and to understand that over time a manager style might change. Someone who starts out buying small cap stocks, as the fund gets bigger and bigger might migrate more into mid cap or large cap territory. Or you could have a portfolio manager leave. You know the fund’s name would stay the same, but perhaps the last investor was a die hard growth investor and the new investor is much more value-oriented.

Back in the days when fund companies just, or funds just have these poetic names, you saw those kinds of massive shifts and strategies that would go on, with the investors not at all being aware that they suddenly had a very different portfolio.

Rick Ferri: Like the Fidelity Magellan Fund.

Don Philips: There was, when we first started doing this, there were two funds called blue chip. Blue Chip Growth I  think one was from T. Rowe Price and the other was from Fidelity. And T. Rowe has always been a real truth in labeling shop and so if they call something blue chip growth it’s going to be what you and your clients would think of as being, you know, blue chip, large cap stocks. I remember we looked at the Fidelity blue chip growth fund and I think it’s median market cap, we placed it just barely in the mid cap, just out of the small cap, and I remember talking to the fund manager and he said, “Well I guess if pressed I would have to say that I think of these as future blue chips.”

That’s great but you’re telling the world that this is a blue chip fund, they think, their expectation of what they’re getting is completely different from what your expectation is in running the fund, and when you have that mismatch of intention and expectation investors tend to suffer and I think the industry lets down its clients.

Rick Ferri: And actually the SEC finally stepped in on that and was sort of a truth and labeling regulation that came out to ensure that if you said your fund had blue chip stocks in it it had better, at least 80 percent, have blue chip stocks.

Don Philips: Yeah it’s true but it gets a little nebulous with something like, well how do you define a blue chip? There isn’t some God-given stamp that said this is a blue chip and this isn’t. But you’re absolutely right, and there was a classic example, again I think it was a Fidelity fund. They had an insured municipal bond fund and John Lanzner at the Orange County Register did a report in his local paper about what’s the exposure to uninsured bonds in all of the different California insured municipal bond funds, and I think then the the limit you had to have was 65 percent, had to be in the type of security that your name suggested, and Fidelity at that time had 66 percent of its assets in insured bonds and the other 34 in uninsured bonds. And the manager said, “Yeah we think insurance is just way overpriced right now, and it’s not worth the premium you have to pay for it.” Well that’s great, but you’re selling this to the public as something that’s labeled as an insured municipal bond fund.

And so it still seems to me that while the SEC has cleaned up on this and gone with an 80% rule across the board, there’s certain words like insured or government or treasury that really pull on investors’ heart strings, and you know today you could put Ford Motor Company bonds in a government bond fund and enhance your yield and not be violating any of the rules. Now in practice we don’t see that much of that kind of shady dealing going on in the industry today. I think it’s a cleaner, better lit, more fiduciary-centric industry than it was perhaps 30 years ago, but I still think you have to be on guard against that kind of stuff because, again, when you have intent and expectations varying greatly, investors oftentimes end up disappointed.

And just look when the credit market imploded back in the financial crisis. You had some things that were called government bond that lost 30 percent or more, and other things that were called government bond that made money during this, and it had to do with how they were interpreting that mandate to invest in government bonds and whether you were buying just the straight forward bonds or you were buying some kind of exotic derivatives somehow linked to government paper.

Rick Ferri: Another benefit of indexing is the transparency. I mean you do know what you’re getting.

Don Philips: Absolutely I mean there’s scores of benefits to indexing, and the longer term view, the tax advantages, the truth in labeling, all of those are there, but that said, you know there’s a lot of craziness under the index umbrella these days. Anytime something gains popularity, and it’s got someone like Jack Bogle at the forefront of it, you’re going to attract shadier characters around the fringes of that, who are going to quote Jack and say, “Oh yeah, you know following in his great tradition, we’re launching a set of market timing triple leveraged index funds and these are good because they’re index oriented.”  You’re like that’s something Jack wouldn’t touch with a 10 foot pole. You really shouldn’t be invoking his name on something like that.

Rick Ferri: I agree. I call it special purpose indexing — spindexing, that’s what it is, just spinning something. I mean the fact is you create some crazy index based on the shoe size of the CEOs and whether they’re left-handed or right-handed, I mean whatever it is you create some crazy index, and then you turn around and you launch an ETF or a mutual fund to that index and you call that mutual fund passive indexing. I just think that the industry is getting away with way too much when they start going down the road of calling spindexes or comparing spindexes to traditional indexes. 

Don Phillips: And then you could wrap yourself in the sacred cloak of indexing and invoke Jack Bogle’s name and say you know that we’re fighting, we’re doing the Lord’s work. You know Jack would be rolling in his grave.

Rick Ferri: Absolutely. I want to get into the rating systems that Morningstar uses. You have two different types of ratings. You have a star rating and you have an analyst rating. So could you compare and contrast the two?

Don Phillips: Well, the star rating is something that Joe had come up with before I joined Morningstar, and it has some positive advantages to it, absolutely. One would be it’s longer term oriented. The minimum period we look at is three years, and if we have a five or a ten year history we weight those more heavily. The second thing is that it’s risk adjusted, so if you go and you take a lot of crazy risk, you produce a very volatile stream of returns, one that investors are unlikely to use well because greater volatility means there’s a greater chance you buy high and sell low, you get penalized for that in the star rating system. And the other thing is that the star ratings include all costs that a mutual fund has. It includes the expense ratio, but it also includes front-end and back-end sales charges. We deduct those when calculating a star rating, and this was a huge improvement at the time it came out back in the mid 1980s. Back then most of the comparisons you saw were things that said this fund is number one in its category, and sometimes the categories were very short-term oriented. It could be or very narrow or very short-term oriented. It might be growth and income funds with assets of less than 25 million dollars, and the performance period might be over the last three months. And the other thing is that all of those number one in category comparisons ignored any sales charges that you might incur. So it was something that really camouflaged the impact of cost, whereas the star rating by including the the loads and by taking a longer term point of view, where the the burden of high expenses takes a greater and greater toll, or at least it’s not camouflaged as much as it can be in short-term results. You know the star rating was something that was a real important catalyst in pointing people towards not only better performing, at least better historical performance and lower risk but also substantially lower cost funds.

And I think that’s one of things Jack recognized right away.  An advantage in what Morningstar was doing is that we were taking an approach that put more emphasis on cost than the industry had done to date and I know people complain about the star rating and say, well it doesn’t tell you this, it doesn’t tell you that. We always say, well first off we never said it told you everything you needed to know,  but it does tell you some things that are of value. And then some people would come and say well I think you should just buy index funds and ignore the star ratings. Okay that’s fine, but traditional index funds have substantially and consistently gotten above average star ratings. And people said, well I think we should just buy Vanguard and Fidelity and ignore these other three fund groups. Well Vanguard has consistently had the highest, or one of the, certainly among the large fund families, the highest average star rating. So there’s something right about them, but there’s also something incomplete. And what we always said is that the star rating is an introduction, not a conclusion. Just it’s a good place to begin to screen down the universe to a more manageable size, because there are tens of thousands of funds out there. You just can’t possibly look at all of them. You need to have some kind of mechanical way of reducing it to a more manageable task.

Rick Ferri: And then you started analyst ratings, where you gave them gold, silver, bronze. This was more forward-looking, correct.

Don Phillips: Yeah, and that was the intent, is that we recognize the shortcomings of the star ratings. In fact we conceded them before most people recognized it. We never ran an ad that said follow the stars to riches, this is all you need. 

Rick Ferri: But there were a lot of ads that said that, but you didn’t say it.

Don Phillips: Yeah, and again you have to go back and say, well what would be better, would it be better that they’re quoting the star rating that’s long term risk and cost adjusted, or short-term number one in its category when you don’t even know what other funds are in the category and you know that it’s ignored the sales charge. So it was an improvement at the time but it wasn’t everything and that’s why we did the analyst rating. And we knew that we produced a whole page of research and the star writing was just one of hundreds of data points on there and oftentimes our analysts would say you know this fund currently has a five-star rating but here’s the reasons why we would be cautious and wouldn’t think that that’s predictive of the future. Perhaps there’s been a manager change or perhaps that it’s just a three-year record, not a five or a ten year record, or perhaps the fund has had a certain tailwind that our analysts thought was unlikely to continue. 

We wanted to get more of that information into the starting point analysis because we knew that some people just stopped at the star rating and so that’s where the analyst ratings came about. As we built up a global team of analysts that was capable of doing this kind of due diligence on funds, we decided to put more of that into a rating so that people could have something that would be more stable than the star ratings and it would include more of our best thinking, because again, we did not adjust a star rating if a portfolio manager left because you never really knew on the outside how important was that manager and how important was the team and all kinds of variables that you didn’t know that were very hard to get into a mechanical thing like the quantitative star ratings but we could get into the more subjective analyst ratings. So that was the intent to give investors a better starting point than the star ratings.

Rick Ferri: So I’m going to ask the tough question here, because you do have advertisements for mutual funds in your magazines and in your publications and such. And they have a tendency to want you to say certain things about them and to give them certain ratings and so forth and there’s a pay-to-play element in the financial media that basically you pay us money and we’ll say good things about your fund and your fund company.  Can you comment number one about the whole industry, and number two about Morningstar’s approach to this?

Don Phillips: You know, we didn’t have advertising in our products for a long time and as we moved into the web we started taking ads. The old research publications didn’t, but on the web you know it’s just part of the business model, and what we did is we said well look to the people we admire most and we look to the Wall Street Journal, we look to the Economist. We said, look there are plenty of examples where you’ve got an editorial function that is kept separate from the advertising and it’s just not that difficult to do if you’ve got the right culture and you set up the right parameters. And we hold our analysts to one standard and one standard only. But the only thing we hold our analysts to is: are you telling the story as fairly and accurately as possible from the investors point of view, and that’s the only standard that our analysts are held to. And our analysts sign their work, it’s out there for the world to see and it’s out there with all of the supporting data. So anyone reading this can look and see okay the analyst says this fund has a consistent history, well let’s go look at the returns how consistent have they been?  So I think it’s as transparent as it can possibly be in a realistic business model for the web. 

Rick Ferri: Let’s talk about exchange traded funds. You were around when they launched the first one back in 1994, and I personally started using them in 1996. So there were only two of them. There were Spyders and Midis, but I could see that this was the future and you picked up on that right away also, that this was the future.

Don Phillips: Sure. Well you were really pressing it, Rick, and you were among the early advisors to really latch onto this. And a lot of advisors wouldn’t because there wasn’t some kind of a commission baked into it. And I think that’s what set you apart is that you’re looking at this from the point of view of the investor. If you were looking at it from the point of view of someone who’s trying to make a buck selling stuff then maybe they weren’t nearly as attractive and that’s why they got ignored for a while. But we came at it from the same point of view as you did, and said look, this is low cost, this is good we don’t see the issue. Now I remember Jack Bogle had a big issue with it, you know he had his shotgun analogy saying you know this is a very powerful tool that could be used for self-defense or for murder and things like that. 

But yeah, and then when Vanguard came up with some very creative ways of attaching them or linking them to their existing funds and the cost or the tax advantages that they have, they really do have material advantages and  the low cost and the transferability of them, to move them from one account to another. There’s some powerful advantages for the investor. And so we were championing them because our moral compass always pointed to do what’s right for the investor. If the investor wins everyone else in the process can succeed. But if the investor is suffering and not doing well then all of us have failed to do our job.

Rick Ferri: I recall when I first started looking into ETFs, it was around 1996 when I had my epiphany, my “aha” moment listening to Jack Bogle and reading his books and coming up with, “Why aren’t I doing this for my client?” And I started looking around. I was working at Smith Barney at the time and I was looking around saying, “Well okay, where are the index funds. I mean where can I find index funds?”  Of course you couldn’t find any index funds. They weren’t available. But by 1998 actually Smith Barney did launch a clandestine index fund. You could find it if you wanted it. We actually had one. It was buried deep, deep, deep down in the Smith Barney mutual fund platform, that was never advertised, and nobody knew about it, but it was there, and you could use it, and it was relatively low cost because they didn’t want people running to Vanguard. But the only thing that I really had available was ETFs and so that’s where I started putting client money. And I remember going to Jamie Dimon and I said to him, he was the president, and I said, “Jamie, you know, we should do this.”  And yeah, no interest in it whatsoever. Now everybody’s doing it.

Don Phillips: It didn’t fit the old brokerage model.

Rick Ferri: No it certainly didn’t fit the model because there was no money in it. There was no 12b-1 fee. There was no, you know, this company, Vanguard, wasn’t about ready to pay any brokerage firm a half a million dollars a year just to get in the door and buy pizza for the advisors so that they tell them about these things.

Don Philips: Pizza’s the least of what the advisors were asking for.

Rick Ferri: Let’s talk about advisors because we’re into this. We talked about the evolution of active funds and how it’s getting tougher for active managers as the world is getting smarter. What about advisors?  And you’ve written a lot about this. In fact a lot of the audience for Vanguard is advisors. You have a big advisor conference every year. How do you see that industry evolving and changing?

Don Phillips: Well it’s been a massive change in my lifetime. You know I think when I, the first advisor I met was my father’s stockbroker, and my dad would go to her for ideas on what stock should I buy, and so the advisor sort of started as people that would pick individual securities. And then in time they said, well you know you’re not really very good at that, you shouldn’t be doing that, you can’t pick stocks but you could pick managers. And so go out and pick active managers. And that kind of became the bread and butter trade of many advisors for a number of years. And then, as we’ve talked about, it got harder and harder to pick successful active managers. And many asset management shops turn into soap operas and the star managers become divas, and they leave in a huff, and all of a sudden you’ve got all these tax consequences, and you’ve got to run and reshuffle. And the case for passive investing just became stronger and stronger. And so the mantra among advisors became, okay we can’t pick stocks, we can’t really pick active managers, but we can pick asset classes. So we can pick a whole bunch of indexes and we can put together a good portfolio.

And that was sort of the model for some time but now I think you’re even seeing that begin to change and morph. Tim Buckley, the new head of Vanguard, in his first couple of weeks as taking over CEO, he started making some statements saying we really don’t think advisors should be putting together portfolios. We don’t think they should be in that business. We think they should be buying model portfolios and that our people can put together these portfolios and manage them and rebalance them better than many advisors can.  

And so if you think about it from that perspective the advisor has been pretty much pushed out of the entire investment part of the investment management process. And the fascinating thing is even with all of these things happening, the advisor’s role and the commitment that clients have to their advisors is as strong as ever. Which suggests that in many cases what the clients really wanted from the advisor, with something other than some kind of mythical investment genius, what they really wanted was some hand holding, and someone to listen to them, and someone to match their goals to an investment portfolio. And advisors are doing that today and providing an incredible value for their clients, even if they’re not picking the next hot stock or the next star manager. 

So I think the role of the advisor has really shifted phenomenally in the last  30 to 40 years, but the importance that the advisor has for the client hasn’t diminished at all. They still, most investors, want to be working with someone as they navigate these difficult financial planning decisions.

Rick Ferri: Although I see the way that advisors get paid is now becoming more in the spotlight. And I’ve been on all sides of it, Don. I mean I started out in the brokerage industry doing commissions, and then went to the AUM, assets under management, business. I had my own advisory firm doing AUM for almost 20 years, and now I’m doing an hourly model. But what I see, again from looking at all these portfolios that I see every day, is I see advisors who want to get assets under management and they do things that sometimes I don’t agree with.

Just yesterday I was talking with a client and his advisor had had him roll money out of a 401k into an IRA that the advisor could manage, and then when the client got another job at a company that had a very, very good low-cost 401k he didn’t advise the client to move that money into the new 401k because he would have lost the assets under management, and that precluded the client from doing a back door Roth and a mega backdoor Roth and he was paying management fees to this advisor. So in other words the incentives of AUM to the advisor caused the advisor not always to make the most fiduciary decisions for the clients.

Don Phillips: Yeah, I think you’re right. There are issues. On the other hand I think most clients prefer it, not having to write out a check, have it collected seamlessly. And from the advisor standpoint it’s delightful. I mean if you can get paid in basis points, what a wonderful way to earn money. I remember, one of the first fund managers I ever saw speak was a guy named Tom Ebright, who ran money for Chuck Royce. I remember him saying, “You know I get up in the middle of the night and I go to the bathroom and I’m making money, I’m getting paid. I  get paid around the clock, all the time, as long as that meter is ticking on the AUM fees.” 

So you know if you’re getting paid on assets under management you have very little incentive to leave it. And as a client, even if you might look at it and say it doesn’t, really there may be some issues that are bad. Most people prefer to pay in this seamless way. That said, I think there are two things that the industry really needs to think about is that the AUM model does not work at all for the small client, nor does it work well for the large client. You know for the small client, if they don’t have any assets, then there’s no incentive for financial advisors to reach out and help these people. And that’s a major issue that’s going to have more and more attention over the next couple of years. How do we reach out to underserved communities? How do we make more people in America investors? Or how do we help small investors become more meaningful investors, and how does the financial planning community reach out to these underserved communities?

Then, on the other hand, advisors have their very successful clients, who may now have, you know, tens of millions of dollars. Maybe they’ve sold a business or something like this. Well for them, paying a percentage of assets under management is a huge huge check that they’re writing, or they’re not even writing it, but they’re paying each year. And as they wise up I think a lot of these people would come back and say, “Hey, let’s negotiate a flat fee. That makes more sense to me.” So AUM doesn’t work from the advisor’s perspective with small clients, and it doesn’t work from the client’s perspective with large clients.

But for the vast majority of people that the planning community works with even though there are issues that you correctly point out that can create perhaps false incentives I think it’s one that’s sort of a preferred methodology or preferred method because of its seamless nature for most participants and most advisors.

Rick Ferri: Well we could have a long discussion about that.

Don Philips: Well I admire you for going to an hourly, as a client I’d prefer that.

Rick Ferri: But it’s certainly not easy because you’re only getting paid for the work that you do. it’s not like that other advisor saying hey this is wonderful you know as I’m sleeping I’m making money. I mean is that what a fiduciary would say? 

Don Phillips: Well yeah, exactly. And you know well you don’t pay your accountant that way, you don’t pay your tax advisor, you don’t pay your estate planning attorney that way. I mean I do think that that the trend is going to be in that direction. But given that AUM is so set up and so established and clients aren’t rebelling against it and for most clients it probably wouldn’t mean a major savings if they did that, it might just clear up some of those potential conflicts. Yeah I just don’t know if there’s a catalyst for moving away from it, but certainly agree with you philosophically that if you paid an hourly basis it would probably be better for the client.

Rick Ferri: Let’s talk about something that is a move away from at least high cost AUM, like one percent or so AUM fees and that is the robo advisor trend.  Vanguard just launched a new robo advisor, a true robo advisor. They have the PAS program, which is point three percent, with you talking to an advisor. You get the same four fund portfolio, but you get to talk to an advisor. And now they’re at a 0.15 percent internet only advisor program, where you’re not talking with anybody but the cost of just getting a portfolio managed using a robo-type platform continues to come down.

Don Phillips: I think this is a good thing. I mean there are many more people that need financial planning than are getting it, or need investment advice than are getting it, and they’re big audiences that the planning community just has to kind of turn their back on because it doesn’t make economic sense to serve them. So the small investor with a 401k plan if they can tap into some robo advice and have a more diversified portfolio and build up a bigger nest egg until they get to the point where a financial advisor would take interest in them, and also before they get to the point where they’ve got the more sophisticated questions that an advisor can really add value on — things about tax decisions, or charitable giving, or estate planning — and all of these, the world of different things that advisors bring to the table. You know, I think this is a good thing, so I don’t see it as a threat. I just see that there’s more work to be done, more people that need some kind of help, and that these are going to be a big part of the future. And I do think that the biggest robo advisors are not going to be some kind of high-tech startup. It’s going to be Vanguard and it’s going to be Schwab and it’s going to be people that already have assets under management and can layer on these additional services at a low cost to the asset management service they’re already providing. They’re going to be the big players here.

 Rick Ferri: One new type of indexing that’s available, it’s actually been around for a long time, but it has become more popular lately is direct indexing. Which is building your own portfolio of 500 stocks and then selling off individual stocks that are at a loss so you can generate tax losses which you can use against capital gain that you might have from selling a business or something, or a single stock position from RSU’s or whatever you have. And this is a growing business. What are your feelings about it? I have mixed feelings about it.

Don Phillips: Well I think parts of it are really cool. I mean I like the idea. I also suspect it’s more sophistication than your typical investor needs or wants, but the great thing to me is you’re seeing a spectrum of opportunities and you can decide to invest at whatever level of complexity that you like today. You can do one-stop shopping, just buy a you know a target date fund or a balanced fund and just leave it there, or you could assemble a portfolio of individual funds, or you can just buy an index fund, or you can create your own index. They’re just so many good solutions out there and you and your advisor just have a decision: what complexity level do we want to play the game at. And I think that’s a wonderful thing.

So I think direct indexing can be a very good thing, but I think most people come to mutual funds because they want it to be simpler and they’re not looking to add complexity. But there are some cases where, as you point out, perhaps you’ve sold a business or you’re selling a business and you’ve got a lot of capital gains, and you want to find ways to offset them. But look at how tax efficient a broad-based total market  ETF is today. What kind of additional benefits are you going to get from direct indexing? And do the costs perhaps outweigh that?  Those are open questions. But the nice thing is that we’re competing on what’s a better offer for investors as opposed to what’s a better deal for those people trying to sell you an investment option. So I see that as being on the positive side of the ledger.

Rick Ferri:  Let’s talk about ESG, environmental social and governance, and the kind of the start and stop that we have seen in this over the years. We’ve had social responsible, that sort of started and then it stopped. Now we have ESG which seems to be getting traction in this social environment that we’re in. Do you think this is it? You think it’s going to grow now?

Don Phillips: I do. I’m in favor of this. I think it’s a good thing and to me it gets back to investor rights, and I think in the early days of Morningstar what we were fighting for is that investors had a right to know how their money was being managed, what the costs were, who the portfolio manager was, what the fund was actually doing. And I think today you can extend that and say, look as an investor today you might have concerns that go beyond just your mercenary ones, and beyond just finances. You want to know what impact your money is having on the world around you. Yeah and you shudder at the fact that maybe you’re making a profit from a company that’s out polluting the environment that your children and your grandkids are going to live in in the future.

And so I think investors have every right to know what impact their money has. So more transparency, more data on environmental, governance, social issues. I think these are positive trends, and I do think we’re going to move from more of a shareholder oriented focus to a stakeholder oriented focus simply because the shareholders have needs beyond their financial ones. They have concerns about the environment, about society, and we’re seeing that with young people very much today. You know my son would not– he buy stocks he buys funds– but he does a lot of due diligence or he does as much due diligence I would say on the ESG factors as he does on the financial ones and I think that’s a trend that’s going to stay.  And I think it’s all about investor rights. That you have a right to know what impact your investments have on the world around you.

Money is a means to an end, it’s not just a goal in and of itself. It’s not some game, or whoever ends up with the biggest pile of greenbacks wins and everyone else loses. It’s about reaching your goals and in defining your own success, and if being a participant in a process that makes the world more the kind of world you want to live in, that’s a very viable concern for your money.

Rick Ferri: Let’s talk about a couple more topics. One of them is fixed income. So we’ve reached an interesting place in history here where interest rates are going to remain very low for a very long period of time. In fact the Federal Reserve is changing the way they operate relative to inflation where– basically going to let inflation rise as opposed to trying to cut off inflation to ensure that it doesn’t get above their two percent target. Now these are all big changes to a financial system that are going to cause — and are causing — valuations of all asset classes to change. I want to hear your feelings about what do you think this all means.

Don Phillips : Well those are great questions because it potentially means that any kind of backward looking asset allocation and research that we do may be of very little utility because we’re entering into a future that’s going to look very different from the past. And the same thing happened when we went off the gold standard. And you need to think about what are the implications of that because suddenly fixed income returns may look very different than they have in the past.

Certainly the benefit of being in fixed income today is much harder to make a pound the table argument for. If you can get a higher yield from buying the S&P 500 than you can from buying a lot of bond funds — especially if you’re looking at a high cost bond fund at a low cost S&P index fund — you know it’s kind of hard to make the case that we need to be in fixed income in a major way.

And I understand that responsible advisors and Vanguard and others still make the case that you need fixed income, and I don’t disagree with that because it certainly adds balance and maybe gunpowder or something or firepower for the future to the portfolio. But the benefits of fixed income, it’s hard to see how you can use that as a major asset towards wealth creation going forward. And it has been an enormous engine of wealth creation for the last 30 years, but I don’t see how you can argue it’s going to be that way for the next decade.

Rick Ferri: I know it’s going to be tough and a lot of people who have retired and relying on fixed income or if they’re going to annuitize their lump sum, the payouts are going to be smaller. It’s pushing people into more risky asset classes and that could have consequences. Also it certainly could cause the market to go to PE levels that we hadn’t seen in many many years.

Don Phillips: Exactly right. The net result is that the investor will be exposed to greater risk because of it, and some of things that people had counted on for their retirement years, the ability to say lock in some a rate of return near the four to five percent rate which would get you those long-term stability of assets that you need in many of the retirement models, you’re not going to get that from fixed income. You’re only going to get it from taking higher risk and that’s a dangerous position to be in when you’ve got the baby boom generation on the cusp of retirement.

Rick Ferri: Yeah absolutely. One final item and that is cyber currencies. Well how long do you think it will be before cyber currencies make their way into Schwab, Fidelity, Merrill, where they become part of the asset mix for advisors and investors.

Don Phillips: You know Rick, I’m not an expert on this so please take whatever I say with a huge grain of salt. I would say that currencies aren’t something that investors have used successfully in their investment programs historically. So I don’t think that aspect is going to become a huge one. What I would say is that you’ll probably see you there’ll be maybe early adopters. I think there are some benefits to these. My guess is that you’ll see Vanguard be among the later ones. They’ll let others go out and test the waters.

Most asset firms that I talk to, they’re interested in the technology behind cyber securities for internal processing, for a lot of different things, but cyber securities as an asset class I think have a long, are probably something on the horizon, but we have a long way to go before you can say that investing in those is a well-researched responsible choice. You know, something that sort of would fit the prudent man rule. And my guess is that a firm like, say Vanguard or a T. Rowe that tend to be more conservative, will let some other firms go out there and test the waters first. And change always happens at the margins — it’s not the established players that are the first to embrace a new technology, it’s some that come along and embrace it and some get burned and others figure out ways to make it work.

And I think if you’re an investor who’s interested in it you’ll wait and see who figures out how to make this work and really benefit a portfolio. You don’t have to be the first to try something. It can still have benefits for you down the road once some of the kinks have been worked out.

Rick Ferri: I see a world maybe when my grandchildren are my age. Yeah I see a world where they might be trading S&P 500 coins globally, along with MSCI  coins and Total Bond Market coins. In other words a portfolio, instead of a portfolio of mutual funds or a portfolio of ETFs, they actually have a portfolio of coins or cyber currencies that have the backing of markets all over the world, where these things trade all over the world.

Don Philips: Just like the pokemon games that they’ve been playing for years right.

Rick Ferri: Exactly. Only this is a 24-hour day seven day a week market and it’s all done through cyber currency.

Don Philips: It certainly could happen. When you and I got into this business would you have ever imagined ETFs and the range of choices that you have in them and how– what a great toolkit the investor today has compared to what we had thirty years ago. Today the toolkit that the investor has is phenomenal. The number of quality low-cost high-quality options that are out there for investing is staggering. I mean today the individual investor has the tools that only the most sophisticated pros had you thirty years ago. So I think we can– it boggles our mind what might be out there thirty years from now, but I can tell you the one thing I do know is that the things that win are going to be those that serve investors well and the failures are going to be those things that over promise and under deliver and disappoint investors.

Rick Ferri: Don it’s been a real pleasure having you on Bogleheads on Investing. Thank you so much for your time.

Don Phillips: Rick, thank you very much and my heart goes out to the Bogleheads. I think you guys are just phenomenal and I know how much the Bogleheads meant to Jack Bogle, and Jack is, you know, one of my great heroes. I saw how touched he was by the love and the affection that the Bogleheads poured out, but more than that I think he’d be incredibly proud by the work that they continue to do, and being out there and being advocates for better investor outcomes and that’s something that I know he would share.

Rick Ferri: Oh, thank you. This concludes Bogleheads on Investing episode number 25. I’m your host Rick Ferri. Join us each month to hear a new special guest. In the meantime visit bogleheads.org and the Bogleheads wiki. Participate in the forum and help others find the forum. Thanks for listening.

Investment adviser, analyst, author and industry consultant

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