Morningstar’s first fund analyst reflects on investing culture, stewardship, and long-term thinking.
Our guest on the podcast today is Don Phillips. Don is a managing director for Morningstar. He joined the company in 1986 as its first mutual fund analyst and soon became editor of the flagship print publication Morningstar Mutual Funds, establishing the editorial voice for which the company is best known. He helped to develop the Morningstar Style Box, the Morningstar Rating, and other distinctive proprietary Morningstar innovations that have become industry standards. Don has served in a variety of leadership roles at Morningstar, most recently head of global research, before paring back his schedule to take on a part-time nonmanagement role. He holds a bachelor’s degree from the University of Texas and a master’s degree from the University of Chicago.
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Amy Arnott: Hi, and welcome to The Long View. I’m Amy Arnott, portfolio strategist for Morningstar.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Arnott: Our guest on the podcast today is Don Phillips. Don is a managing director for Morningstar. He joined the company in 1986 as its first mutual fund analyst and soon became editor of the flagship print publication Morningstar Mutual Funds, establishing the editorial voice for which the company is best known. He helped to develop the Morningstar Style Box, the Morningstar Rating, and other distinctive proprietary Morningstar innovations that have become industry standards. Don has served in a variety of leadership roles at Morningstar, most recently head of global research before paring back his schedule to take on a part-time non-management role. He holds a bachelor’s degree from the University of Texas and a master’s degree from the University of Chicago.
Don, welcome to The Long View.
Don Phillips: Thank you. It’s great to be back.
Arnott: Great to have you here. A lot of our listeners are probably familiar with the Phillips Curve column you write for https://magazine.morningstar.com/?section=issues every quarter. How do you come up with ideas for the column?
Phillips: For me, everything starts with what are the issues and challenges that investors are facing? And then I come back and think what can I contribute or what can Morningstar contribute to help encourage better outcomes for investors? So that’s really the playbook. It’s been the playbook from day one at Morningstar and the things that we write, the tools that we come up with, and now it I guess carries on to some degree in my column.
Benz: When we had a going-away lunch for John Rekenthaler, his retirement, he described himself as a 50,000-foot-view thinker, and he said you were a 100,000-foot-view thinker. Have you always taken a more strategic view of the fund industry?
Phillips: Well, I guess what John is saying is that both of us have our heads in the clouds. But yeah, I mean, it’s just sort of the way I’m wired and the way I think. And John’s right that I’m not the best detail person. You get down into the weeds. I want to get up and you’ll get the whole story. What’s the big picture? What are the key things that you have to keep in mind and the things that are going to guide you? Because I’m always looking for those guideposts and those horizons. And one of the things I’ve noticed is that a lot of the best investors have a similar sort of mindset. Yes, they can get down, they can do all the accounting minutia, but they have a theme. Why do you own this stock? And they keep that in mind and what’s your direction? What’s your north star? And if you’ve got that, then a lot of other things simplify themselves.
I tend to be someone who takes a lot of information and then tries to come up with a condensed, consolidated view. And I always think of that Blaise Pascal line: I write this letter long because I lack the time to make it short. What I like is those key points that center your discussion and keep you focused over time.
Arnott: You’ve been at Morningstar since 1986, when you were hired as the first analyst. What has surprised you most about the way things have changed for the company or the industry over the past four decades?
Phillips: For the company, to me, it’s just I look back with amazement and see how much you can do if you just focus on taking the next step. It was always just … People think, oh, you must have all these strategy sessions and talked about where you wanted to be 30 years from now. And I know Joe still gets that question regularly. And he’s like, “Of course we didn’t know what was going to happen 30 years from now.” You don’t know all of those things. You may have some basic plans, but you can basically assess, is there a need out there? Can we fill it? Can we use technology to do something that the competition can’t? Are we doing something that’s beneficial and helpful to people? And then you just focus at the task at hand, getting the next issue out, getting the next column out, coming up with the next data point, collecting the next data point.
And just that step after step. It’s amazing what you can accomplish if you just keep focusing on that and keep focusing on your competitive advantages. What can we do that the competition either can’t or doesn’t have the courage to do, and is it in the right direction? Is it helpful for investors? For the industry, I look back, and it’s changed incredibly. And one of the things that’s really surprising me is I think the whole attitude toward professional fund managers. And it used to be these, people thought of these, these were gods that walked the earth and “oh, I’ve read Peter Lynch’s book” or “I’ve read this by John Templeton or Warren Buffett.” And they were heroes, and it probably got overplayed to a certain degree because, at the end of the day, these are still just people, and they have their foibles just like all the rest of us.
And we’ve all seen cases where a fund manager’s ego has been detrimental to shareholders because either they get too full of themselves in what they’re investing in or they get pissed off with their employer and they leave and then investors have to jump through all kinds of hurdles to stay with them. But today it amazes me if I tell people that “gee, I track mutual funds,” you get this reaction, “Well, why do you bother? Don’t all the managers trail the market?” And so we’ve gone from one extreme of managers are superhuman, amazing people to they basically collectively add no value whatsoever. And the truth is obviously somewhere in the middle, but it amazes me that we’ve gone from one extreme to the other just in the time that I’ve been actively tracking the industry.
Arnott: Yeah, it’s interesting. We’re going to be talking to Will Danoff at the conference in June, and he’s been managing Contrafund at Fidelity as an active manager for more than 30 years very successfully, but he’s really kind of an outlier nowadays of someone who’s an active manager and a stock-picker and has been able to do that well.
Phillips: And I don’t know how many people today would be given the range and the freedom that Danoff has gotten over his career. I mean, the industry’s changed. It’s become much more professionalized and a little less entrepreneurial, a little less gunslinger, which is maybe a positive, but you lose something as well. And a couple of things that I think Danoff always did really well—I know that he always had a letter from an early shareholder just talking about how important this was, how their investment in his fund had really enriched their lives and allowed them to do things they otherwise couldn’t have and put them in a firmer financial footing. And that’s something I think that gets lost. A lot of people just forget the purpose of what you’re doing. And I think the best fund managers have that connection, and it’s not just a game, having a higher return for someone else, but you realize that you’re doing something positive and you’re helping people’s lives.
And I think many of the great investors feel that connection and it gives their work much more purpose and makes it more of a cause as opposed to just a paycheck.
Benz: I have a great anecdote about Danoff in that context, Don. I met an investor at a conference a couple of months ago, and he had just retired, and then we corresponded via email a couple of times since. And he sent me a letter that came from Will Danoff. He had written Danoff to thank him for his contribution to his successful financial plan. This was a person who had started out in fairly modest circumstances, and Danoff wrote him back, and you could tell that he had read this gentleman’s letter and was responding to specific aspects of it. So it warmed our hearts. I sent it to Amy. It was really just a lovely thing to see.
Phillips: That’s a wonderful story.
Benz: Don, one piece of feedback I sometimes get from people who, when they think about active management, they say, “Well, even if there have been managers who have outperformed, there’s no way to identify them in advance.” What’s your response to that point?
Phillips: Well, I’d say it is difficult to do that. And there have certainly been cases that we’ve all seen where we’ve had a manager that you really admire and then something goes off the wires, and maybe it’s the egos get in the way, or the fund gets so large, it can’t perform. But I still think there are characteristics you can look for that are positive, and you can take from the past and project into the future. And certainly taking from the past and projecting into the future makes more sense than looking for things that historically have done poorly and then buying them on the hope that somehow they get their act together. So I do think it makes sense to look at people that have produced better results, but you really have to look at the whole environment that they’re operating in. A fund is such a complex thing.
You’ve got to think about what are the marketing pressures, what’s the organization, what’s their style, what sort of pressures are on the manager. I always come back to the main thing I look at when I look at an asset management company and then the context within which a manager has to perform, I just think of this spectrum from salesmanship to stewardship. And salesmanship is a spectrum that says, If we had an offering like this today, would it be easy to sell? Stewardship is a different mindset that says, If we sell something like this today, how are people going to think about us five, 10 years down the line? And too often you have maybe good managers, but they end up in a sales-oriented environment where they get all these pressures to do things in the short term that make the fund more attractive to sell, but maybe not better to buy and to own.
And so you want ones where managers have that control. They’re in a stewardship environment, and they’re thinking about what’s the experience we’re creating for investors, not just are we creating a product that’s easy for our sales team to sell?
Arnott: Yeah. I wrote an article recently focusing on some of the most successful actively managed funds, and one of the fund companies that was near the top of the list was American Funds. And in thinking about what has made them successful, I think it’s exactly that, that they have never compensated their managers based on assets under management. They’ve never had a sector fund. They have stayed away from a lot of the gimmicky things that might’ve helped them in the short term but really wouldn’t be in investors’ interest in the long term.
Phillips: Yeah, that was a great article. And I think some of the best work is—or maybe the most important work we’ve done at Morningstar is—looking more at manager incentives and manager compensation. I remember when we started grading that and started asking fund companies for more details on that, one fund company came to us and said they had set up their whole manager compensation around creating incentives for them to be in the top decile of their category in each calendar year. And they said, that seemed like a great idea at the time. But then we realized what we were doing is we were creating horrible sets of incentives because if a manager was behind his or her benchmark in, say, October or November, their incentive was to gun the fund, take wild, crazy risk in the hopes that they would work out and they would get a big payout that year.
And if they didn’t work out, if they blew up, well, they didn’t care because they got a brand new score sheet Jan. 1. So they said, “We realize we created this incentive that was basically encouraging managers to scar their long-term performance records.” And this is where you get into a real misalignment, where oftentimes managers are very focused on some sort of artificial compensation structure that’s guided on the next quarter or the next couple of quarters, and yet they’re turning around and offering their services to investors who are thinking about the next 40 years. And when you’ve got that mismatch, that short-termism versus the long-term view, that’s almost certainly going to be one of those kinds of problems that face investors, that are the kind of things that I like to work on in my commentaries or that we like to work on in our tools is to get people on the same page and the same wavelength and thinking along the same time horizon so you’ve got a better match between how the fund is being managed and what the investor’s expectations are.
Benz: As indexing has become the dominant investment approach for most investors and the advisors they employ, does that create any blind spots for people?
Phillips: Well, I think we’d all agree that the rise of indexing has been a positive, and it makes the default choice much easier. It’s much easier to get to a good investment program today than it ever has been. But I can’t help thinking that something’s lost. And I think about Joe Mansueto, who started Morningstar, and I remember he was asked once, “What did you do before you started Morningstar?” And he said, “Well, frankly, I was an investor. I loved investing. I loved Warren Buffett, but I spent a lot of the early ’80s just thinking about, What are the characteristics of a good business?” And I think, if you think of investing as understanding businesses, what makes them tick? You can learn so much. It can be an incredibly rewarding experience.
I think of Haywood Kelly, who was a longtime Morningstar employee, worked in our equity research, he said he loved to follow a dollar through a company and think about where it goes and how it gets siphoned off in different areas and think about what are the trade-offs, what are the consequences if you put more money here versus there. And just that knowledge of what makes a good business is something that is lost if you put all of your investing on autopilot. And not everyone needs to think about what’s a good business and develop that skillset, but you get something really rewarding from taking that deep dive.
And an analogy I’ve been thinking of lately, I saw one of the Big Tech moguls say, “Oh, it’s silly to learn a foreign language. I’d never have my kids do that because you can just get a translation type thing.” Well, yes, you can get a translation, and you can figure out at some level what someone’s saying, but to really understand a culture, the way people think, the way they approach it, learning their language and the choices that that language makes and how it’s different from another language, you get such a richness of experience, and not everyone can do a deep dive on everything.
So it’s great that we can have these autopilot solutions. Yes, you can get your Google Translate. Yes, you can just buy an index fund, but you can’t put everything in your life on autopilot. At some places, you want to engage deeply and really immerse yourself and learn much more of the subtleties and the extra things, because on that journey, you’re also going to learn a lot about yourself. And so I think indexing is terrific. I think it’s the right choice for the vast majority of investors, but I think also of Benjamin Graham, the night before he passed away, supposedly he was at a desk doing securities analysis. He just loved the process. He loved understanding businesses. He loved asking questions, and indexing gives you maybe the right not to ask a lot of questions, to sort of ask-the-audience answer, buy the collective thing.
And that is a terrific outcome, but hopefully you’re finding other parts of your personal finance or just other parts of your life to do that deep dive on with all the time you’re saving.
Arnott: You mentioned the power of AI in maybe giving you a surface-level translation. And obviously, there’s been a lot of excitement and fear about the potential impact of artificial intelligence. How do you think AI will reshape the landscape for investment research and financial advice?
Phillips: I think AI, like indexing, will make it easier to get to a good answer. And for a lot of people, that’s going to be a positive. But I think wise users of AI won’t just accept the quick, easy, good answer that you get, but they’ll continue to go back and ask AI agents more questions. I mean, that’s what you really want to use this for—as a tool to refine your thinking. And ultimately, the responsibility for thinking has to lie on the user. You have to be engaged in thinking and trying to learn and not just looking for an answer—or a quick and easy answer, but how do you dive in deeper? And so, if you use AI to go deeper, if you question AI, if you get it to refine your thinking, then it’s very, very positive. But I think it’ll revolutionize the investment industry.
I mean, one of the challenges of investing is you’re just given this overload of information to make sense of, and perhaps AI will make it easier to deal with that. But that said, I remember going and interviewing different managers in the early days, and one manager said the best thing they could do for their clients is to go on vacation. And you say, “Why in the world is that? ” And he said, “Well, if I go into the office, I’m going to stare at a computer screen. I’m going to see all of this minutiae, all of this noise in the market, and I’m going to try to add value for my client by reacting to that, and I’m going to lose sight of the big picture.” And so if AI can get you out of the minutia into the bigger picture, then that’s a very positive thing.
If it’s something that just draws you more into the minutia, then I think it will have serious pitfalls. But I think the overall thing … Well, we can argue whether it’s a good or a bad thing. The reality is it’s happening. So the real thing is: How do you deal with it, because you don’t have the choice to just turn it off? How do you use this tool as effectively as you can?
Benz: I wanted to mention Jeff Ptak did some research where he looked at if portfolio managers just walked away from their portfolios and froze them that they would’ve actually done better. So is the lesson there that managers should do less much of the time?
Phillips: Well, yeah, Jack Bogle had the wonderful line. It’s like, “Don’t just do something, sit there.” And yeah, I think you’re right. I mean, it’s through all the … We’re wired to try to help and to try to do the best thing, and so the best intentions, but you end up overreacting to the noise in the market and losing that big picture thing. And so maybe you need a few people like me and John that are thinking at 50- or 100,000 feet in an organization. You certainly need the other people that are in there in the trenches sorting through all the minutiae, but you need that combination.
And I think one of the things that is a major thing I’ve learned at Morningstar is anytime you can look at something from more than one angle, it’s a positive. I remember when, well, I mean, we weren’t big fans of, say, technical analysis, and we weren’t big believers in some of these alternative ways of looking at the market, but how can it be a bad thing to look at something from a different angle at the same time?
I mean, Fidelity had the chart room for years. There are things you can get out of that. And you may say that this is my preferred way to invest, that you go in and you do fundamental analysis, but sometimes if you look at things from a top-down angle and a bottom-up angle at the same time, that’s very positive. And we tend to gravitate more toward stock-pickers and people that are bottom-up investors, but some of the best podcasts that you guys have done have been with economists who can look at things from the top-down. So anytime you can look at things from multiple angles as opposed to just the one that might be your preference, I think it’s a big positive.
Arnott: Another topic we’ve been hearing a lot of buzz about lately is private assets, so private equity and private credit. There’s been a pretty big push to make things easier for plan sponsors to add those types of assets to 401(k) plans. What are your thoughts on encouraging broader adoption of those types of assets in retirement plans?
Phillips: Well, I think I’m going to see more and more of this, but to me so far, there’ve been a number of pratfalls. I mean, you look at the Blue Owl situation, and right now there’s a bunch of name-calling going on. I mean, people pushing the blame on the other side. One of our executives was at a private credit conference the other day, and he came away and said, “They just keep talking about how wrong individual retail investors are. They just don’t understand private credit. What’s the matter with them? These gates are really for their own protection. It’s a good thing.” And the other day, a very senior tech executive said, “The problem is that retail investors just don’t understand private credit.”
But I think it goes the other way, too. Private credit doesn’t understand retail investors. Retail investors, if you look at managed investment products over the last hundred years, you move from unit investment trust to closed-end funds to open-end funds to index funds to ETFs, the whole move, every move has given investors either greater diversification, lower cost, or more liquidity. And now all of a sudden you look at private assets, they move against all three of those trends. They’re going to be higher costs, they’re going to have less liquidity, and they’re going to be more concentrated. They’re not going to have the diversification of a broad market index. So everything retail investors have been trained on for the last four or five decades, as this has really become the starting place for building portfolios, now the industry is reversing course on all of those things, and they’re wondering why investors aren’t prepared for this.
So you look at, say, now fixed income, what happened with Blue Owl, for example, the roots of fixed-income investing in the mutual fund industry really came from the money market fund. You go back to the ’80s and most of the money, the personal savings, was in banks and passbook savings accounts paying 5.25%. And it was when money market funds could offer a double-digit yield that they were able to pull people out of the banks into the mutual fund industry. So money market funds were the calling card that got a lot of investors into mutual funds. And then when money market funds’ yields went below 10%, then the industry migrated them to government-bond funds with much longer maturities, and then they moved them to corporate bond funds and then to high yield. And it’s been a move down where you’re always taking on more and more risk, but the mindset has still been about this is like a money market fund.
And you think about mutual fund, bond-fund namings, they always highlight the most comforting aspect of the fund, not the most salient. I mean, no one ever bought a “low credit-quality bond fund.” You bought a “high-yield fund.” And if you see something that’s called an “investment-grade bond fund,” well, we know that’s a euphemism for single A. And most investors, they don’t know that, well, there’s single A and then there’s AA and there’s AAA—that it’s more middle of the pack, perhaps, if it’s called that. That, I think, is the issue. And the industry plays up, in their marketing, the safety and the security. Think of government-bond funds that have pictures of the flag festooned all over the marketing materials and the shareholder reports and the capital dome, and yet now all of a sudden you’re in things where you are taking credit risk, and there’s nothing wrong with taking credit risk if you know you’re taking credit risk. And unfortunately, the industry tends to soft-play that information that you need. I think that’s why people were really surprised with Blue Owl because their expectations were—this is like a money market fund; you shouldn’t expect it to break the buck.
Now you’ve got the private credit people saying, “Well, it’s not that big a deal.” And you could say the same thing about a money market fund, right? It goes from a dollar to 99 cents. It’s not the end of the world, but it broke the buck. You broke the promise or the expectation that you had created. So it’s a first date for both sides. Retail investors are new to private equity. On the other hand, these private securities offerings, they don’t really understand the retail mindset.
And what we can just hope for and what I think Morningstar is working for is how do we increase the odds for investor success here? Because in the long run, if the investor doesn’t win, both parties are going to suffer. So trying to get a successful first experience and then build from that is, I think, the most important thing, as opposed to how do we get assets into this as quickly as possible.
Benz: With privates in the hands of retail investors potentially, what do you think of the Bill Bernstein argument that the lower-quality players will be the ones who are willing to sell to the retail space and that the better private operators will stay where they are and not be in the retail space?
Phillips: Well, there’s certainly that possibility. You certainly look at what happened with the hedge funds and how many financial advisors wanted to mimic the Yale model, but they didn’t have access to the same caliber of hedge fund that David Swensen had and said they were buying retail offerings that may have been done by lesser players and certainly with higher fee schedules. So yeah, you always have to look at that sort of thing and where the innovation is coming from. I think Bill’s almost always right about these things. I think that is a good insight, but it’s going to happen. You’re going to see more of these things happen.
One of the things that worries me a little about this whole love of private investing and people want to get to the SpaceX and a couple of situations like that. One of the things I think we’re forgetting is just how good public markets are, how beneficial they are for investors.
I remember before Morningstar went public, Joe talked about it and said, if we go public in the US markets, we are accepting the highest level of transparency and accountability anywhere in the planet. This is the cleanest, best-lit playing field, and investors benefit from well-lit playing fields. And now people are saying, well, we have to find ways that private equity money can tap into retail money so they can get the benefits of being like a public company. But I think we should also think about are there things we can do on the public company side to make it easier to be public, to make the reporting a little less onerous to make more companies want to be public. Because the ultimate goal for, I think, investors and the investment community would be to have more companies in the public arena where the sunlight is better, rather than now more of this moving to the shadows or the sidelines.
But it’s going to happen in some ways, and there’ll be compromises on both sides, I guess. But one of the things that clearly is going to happen is that the investors’ toolkit is going to get wider and wider, and that’s a positive, but it also means that there’ll be challenges in how to navigate some of the new things that are coming in.
Arnott: You’ve also written about other innovations in the industry like thematic funds or crypto funds, and you’ve often been skeptical of those types of innovations that seem to be driven more by an exciting narrative than an investor need. What kind of warning signs do you think tend to emerge first when a new product is launched that might tell you, “This sounds great on paper, but maybe it’s not something that I want to get involved in”?
Phillips: I just come back to my salesmanship versus stewardship, asking yourself, Is this being offered because it’s easy to sell or because it’s good to buy? And the ways you can tell that—Well, is this the faddish thing? Is this the thing everyone’s talking about? Am I just being encouraged to jump on the bandwagon, or is this something that really is aligned with my long term horizons? And one of the things that I think about, I think the fundamental question that all of us in and around the investment management industry have to ask is, Are we going to be a part of accelerating the fear and greed cycle, or are we going to be a part of moderating it? And I think the great financial advisors and the great personal financial wisdom are all working on moderating those fear and greed cycles, but you can make a lot of money playing into them, offering something that people are eager to buy, something that’s a hot topic.
And what you do then is you encourage people to buy high and to sell low and that leads to terrible outcomes. And to me, I always just back it up to: What’s the investor outcome going to be? And one of the things we know is that people go back to places where they have good outcomes, and they shy away from places where they’ve had bad outcomes. The single best litmus test of whether an asset management company gained market share in the first decade of this century was whether or not they launched an internet fund in the last decade of the prior century. Those that launched the internet funds were the ones that were the salesmanship mode. This is the easy to sell today. This is in the news, and people want to buy this. Those that didn’t, and there were credible groups like Capital Research and Vanguard and Fidelity.
Fidelity had all these sector funds. You could buy a sector auto-parts firm, but you couldn’t buy, they didn’t offer a stand-alone internet fund. And so I think companies ultimately define themselves by the products that they offer and the timing of when they offer them. And I would always work backwards. If something’s being offered to me, say, Are they doing this because they really think it’s good for me to own, or it’s easy for them to sell?
Benz: Do you think that very basic products like annuities, very basic income annuities and other boring tools, are they undervalued because they solve problems rather than address things that the industry prefers to market?
Phillips: That’s a really good question. I mean, annuities have a bad name because a lot of times these have been designed to make them attractive to the person selling them as opposed to the person owning them. That’s changing, and there are some terrific offerings there, but I think we have to really change the mindset. People think of investing as a game and who ends up with the highest pile of cash, wins that game, but you really need to realize that investing is a means to an end, and things like annuities are something that fit into that and can be a very helpful part of giving people greater security. And to me, the whole reason that you help people with investing is that you give them that kind of security, that stability so that they can know that their financial future is firm, so that then they can go and pursue their dreams, do the things that really matter to them.
And hopefully what matters to them is not just piling up the biggest pile of money, it’s figuring out what you can do with your life, figuring out what kinds of things are really important to you, and then devoting more of your time and energy toward those. And so I think annuities are probably not used enough, but there’s earned distress there, because these have been some bad products in the past. And so it’s a long road to get back. Once something gets a bad reputation, it’s really hard then to win it back. Warren Buffett’s line, a lifetime to win a reputation and five minutes to lose it. And that’s one of the things that concerns me with private credit right now. It’s getting a tarnished reputation because the initial experiences are bad. And what I want to focus on is trying to help people have good experiences with this, make sure they get into it with their eyes wide open, they understand the risks that they’re taking, and that the industry hasn’t camouflaged those risks and gotten them into something that’s inappropriate for them or something that they’re not quite ready to utilize.
Arnott: When you look at the asset management industry or the financial advice industry, what do you think are the biggest unmet needs that companies should be thinking about as they’re looking to develop new products and services?
Phillips: I think the industry is still so very focused on the accumulation process, and it’s a very attractive process for the industry. As assets grow, they make more and more money, especially as you move to more ongoing fees as being the revenue stream as opposed to say a one-time charge. I think the industry just is not nearly as focused as it could be on the decumulation side of the ledger, and also taxes, tax management. We focus so much on finding a slightly better manager in the accumulation phase, and you can spend a lot of time and energy doing that, but after you’ve accumulated money, just making the right tax decisions to get out of there. And this is where financial advisors add a tremendous amount of value. And of course there’s that inverse pyramid that gets talked about. It’s the value that they’re adding is oftentimes not at all where their compensation is coming from, but helping people make better tax decisions.
I mean, we can argue as long as we want about whether markets are efficient. The one thing we know for certainty is that the tax code is not efficient. And so being more upfront about some of these things that are sort of negative things people don’t like to talk about. They don’t like to talk about the end of their life, so they don’t want to think about annuities and how much longer they’re going to live. They don’t like to think about decumulation and the money going away. They like to think of the pile getting bigger and bigger. But these are the things that, if you really want to think of the investor’s whole cycle and having success, you need to incorporate all of those things that are a little less rewarding, maybe a little less enticing, a little less enjoyable to talk about, but they’re part of the process.
Benz: I’m curious, Don, financial advisors, I think we can all agree, can add a ton of value for their clients. Do you feel like we could be doing more to help with accountability of financial advisors? There’s so little transparency for consumers in terms of knowing what to look for in an advisor. I think about how fund products, people are increasingly gravitating toward index funds. So in some respects, we’re not really seeing accountability in the way that we were able to do with active managers by monitoring their performance that it’s sort of over here with the asset-allocation decisions, which no one’s really tracking. Can you talk about that, whether you’ve thought about that as part of Morningstar tracking advisor performance in any fashion?
Phillips: That was always the most difficult question I would get when I’d speak to a group of individual investors is that someone would inevitably come up at the end and say, “Well, how do I know if I have a good financial planner? How do I find a good financial planner?” And the best analogy I could come up is, “Well, I don’t know how to fix my car, but I know if I trust my mechanic or things like that.” And you’re right, it seems like that’s still in a very analog area. It’s like, do you have trust, or do you not? And obviously a lot of subtle information goes into forming that opinion, but you’re not really just scrutinizing all of the facts and the evidence and the comparisons. And maybe that’s a good thing. Maybe that encourages more loyalty that you’re not constantly second-guessing, should I leave this advisor for someone who’s a half-step better?
But it’s a tough question. I think it really comes down to the radar that you’ve developed over your lifetime about the people that you trust, the people that you want to spend time with, and gauging the benefits that you’re getting from a relationship. And so maybe it’s one of those things you’re best not overanalyzing because you’ll end up making short-term decisions. I mean, I think of people that were early on at Morningstar that got a job offer for $1,000 more a year, and they jumped ship, and yet you knew that they maybe wanted to be here and things like that. And there are many times you can be penny-wise and pound-foolish in that. So I think long relationships are really valuable. Long relationships with the investments that you hold, with the people that you know. Certainly no one would argue that in your marriage, you should constantly be saying, “Can I upgrade my spouse every couple of years?” You want to kind of stick with these things, but you do need some evidence.
It probably would be beneficial if there was a little more transparency in the financial advisor space. But I think right now you just have to go with your gut. Am I happy with the relationship? Do I seem to be getting good things? Am I making progress on my goals? Do I feel secure? Do I feel that I can focus on other things because this person is taking care of this part of my life? And if you can answer that, then you probably have a pretty good advisor.
Arnott: I’ve also been surprised that even though there’s been such a positive trend with costs coming down on the mutual fund side and other managed investment products with a shift toward passive and cost decreases for actively managed products, but if you look at financial advice, that 1% fee based on assets under management has been remarkably sticky. And if you think about, for a small investor, that can be a significant amount of money in dollar terms and really chip into your results over time. So why do you think that pricing pressure really hasn’t migrated to the financial advice side?
Phillips: I think it’s because the pricing is so seamless and you don’t see it. And most people don’t do the math on it. They don’t understand the power of compound interest. They don’t understand the cumulative costs that they’re paying. And if it’s out of sight, out of mind, it doesn’t get scrutinized.
I remember one of the very first times I saw a fund manager speak, it was Tom Ebright who was with the Royce organization, and he was talking about how amazingly great it is to be paid in basis points. He’s like, “I’m getting paid around the clock. I get up in the middle of the night and go to the restroom, and I’m getting paid for that. ” Maybe not for that, but I’m getting paid while I’m doing that. And that basis points and seamless and never having to write a check for these sort of things, if you can be compensated that way, it’s an amazing way to do it.
But the amazing thing is that much of financial service has been able to position this as a real benefit for the investor, is that you don’t have to write a check for us, that we do better as you do better, that our fee is just subtracted from your returns, but they never sit down and say, “Well, that 1% when I came to this advisor with $10,000 was this dollar amount. Now that I’ve got $10 million, it’s the same fee, and now it’s a much bigger charge. And would I realistically look at this and say, that’s an amount I would pay?”
And I remember Bogle used to make this example with some of the big money market funds that were out there, and he would talk about how massive the fund was, and that their expense ratio seemed low. He goes, “But if you take those 20 basis points, and you multiply it by the billions of dollars they have under management, you realize they’re making an enormous amount of money for running this money market fund.” And Bogle used to say, and I’m sure the Vanguard people won’t appreciate this, but it’s like, what does it take to run a money market fund? It’s just a couple of people and a computer terminal. And apologies to money market managers out there. I know it’s more than that. But that was Bogle’s phrase—is that the costs are relatively fixed, and that if the assets go up and the percentage that you’re taking stays the same, it goes from being what maybe initially seemed like a reasonable amount to pay for this to something that’s just egregiously well compensated for the people providing the work. But the people that are paying the bill, their attention isn’t drawn to it.
Arnott: Yeah. I think if you looked at the amount in dollar terms, if you’re paying $10,000 or $20,000 a year, you might stop and think, “Well, am I really getting the value that I would expect from that?”
Phillips: “Or should I renegotiate?” And smart organizations, they negotiate on the dollar terms, and they sell on the basis points.
Benz: Going back to investing, you’ve described fixed-income funds as the industry’s Achilles’ heel. Why do you think risk incentives break down most often there, even among experienced managers?
Phillips: I think with fixed income, a couple of things come into play. One is that investors’ expectations are really grounded in money market funds. There’s a high level of security when you’re in a bond fund, and the industry plays up to that with the way they name the funds, with the way they market them—they’re always drawing your attention to the most comforting aspect of that fund. But then you get into a whole bunch of mathematical problems with fixed income, in that oftentimes these things are evaluated and bought and sold on the basis of yield. And of course, your yield is a function of your expense ratio. So if your expense ratio goes up, your yield comes down because you have to pay your expenses out of the yield stream, and that creates a huge amount of pressure on managers. If you’re saddled with a higher expense ratio than your peer funds and your bonus is based on how well you do relative to your peer group, which it almost always is, well, your incentive now is to go out and take risks that you otherwise wouldn’t have taken to overcome that disadvantage that you’ve been dealt.
And so it ends up being a very vicious cycle where people are chasing yield, they’re focusing on that, and they end up taking risks that maybe they otherwise wouldn’t have taken, and oftentimes risks that they’re not communicating to their clients. And so right now, I think one of the big issues with the industry, you look back to the financial crisis, there were some firms who just had a fund that was labeled government-bond fund and another fund would have the same thing called government-bond funds, two funds that were positioned just the same. One was a plain-vanilla fund, the other was doing a lot of esoteric-type of trades and dealing with derivatives. And there’s always ways to complicate a fixed-income portfolio with all of the things that happen in the derivative markets and areas like that. And to the public, they’re both sold as government-bond funds.
And you have to be an insider to know this is a plain-vanilla one and this is the one that’s doing something more esoteric. Now, a lot of good stuff happens on the esoteric front. Some of the most sophisticated bond shops like Pimco do very esoteric things. But if you were to go back into the financial crisis and just put funds into those two buckets, and our analysts could have done that easily, you would’ve found that none of the blowups happened on the plain-vanilla side. All of them happened on the esoteric side. It didn’t mean that every fund that was doing something esoteric blew up, but all of the blowups would’ve been in that bucket. And that’s something that I think we need to do a better job of with investors is helping them understand when are there outliers within a category—for managers that are doing something fundamentally different, maybe they’re running a much more concentrated portfolio,
increasingly, maybe they’re using more private equity or private assets in the mix, and someone else is doing something that’s much more conventional. Just understanding the difference between the conventional approach and the newer, more fringe approach, and communicating that effectively to the people using it will go a long way toward improving investor outcomes.
Arnott: And I think that is something that Morningstar has always put a lot of emphasis on is actually looking at what’s in fund portfolios, which, when you first started, people, to the extent that they could even find information about funds, they would be focusing on returns. And I think Morningstar was really the first company to put so much focus on what’s actually in the portfolio.
Phillips: The vast majority of fund analysis, I think before Morningstar, was really a form of technical analysis. You were looking at the shell of the fund, its price and dividends, and then how that moved. And without understanding what built that, what was the cause of the performance? And without doing that work into what the fund’s actually investing in, you can’t understand headwinds and tailwinds. You can’t understand why did this fund succeed at one point, and another fund, a different fund, and you can’t even begin to put together intelligent portfolios. If you just buy a bunch of funds that have all succeeded in the recent past, say, buying off of last year’s leaders list, almost definitionally what you’re doing, you’re creating a false sense of diversification because you’re layering a bunch of different funds, maybe with different names from different organizations, together, but because they all succeeded at the same time, it’s very likely that they’re investing in essentially the same things.
And so you get this false sense of diversification. You think you’re diversifying, when in reality you’re just multiplying your bet. And that’s something I’m really worried about right now with private equity. I had a conversation with Kunal Kapoor recently, who said he had talked with Bill Nygren from Oakmark, and Bill was saying how the S&P 500, we think of it as the broad market, but it’s become very concentrated because of the Mag Seven, certain sectors, a handful of companies really dominate this, that he thinks of the S&P 500 today as a much more concentrated bet than it’s been historically. And I think the irony right now is that you’ve got a lot of individuals and maybe financial advisors saying, “Well, we’ve got a lot of people in conventional S&P 500 broad market type investments. We need to diversify. Well, let’s go into private equity.”
Well, private equity may be trading differently, but the private equity world is a herd mentality. No one’s buying concrete companies in private equity funds. It’s all AI-oriented, all tech-oriented. So you move into private equity today, the odds are that you’re actually concentrating the bet that the broad market of publicly traded stocks is already making. So you have this illusion of diversification. And again, there’s nothing wrong with running a more concentrated portfolio except that if you think that you’re diversifying when in fact you’re concentrating. And we do know that, historically, investors have used concentrated portfolios less well because their performance tends to be more extreme, and so people are more likely to be tempted to buy high and then to sell low.
And the whole talk about private and public convergence, talk to some of our people that deal with Washington, and the regulators are very focused on liquidity, and they’re very focused on cost. But I think one of the things we really have to think about is concentration.
That’s a risk that is embedded in private equities because of the herd mentality there. You’re going to be much more sector-concentrated and perhaps much more concentrated in a handful of names like a SpaceX or something that dominate those indexes. And we know that concentration is something that routinely investors find very difficult to deal with. They don’t use concentrated funds well. And when we’ve looked at investor returns, and Amy, you’ve done seminal work on this, you realize that some of these more concentrated funds that soar very high and that come down very hard, investors really don’t use them well. And some have amazing paper records, but if you dig a little deeper, you realize that they’re actually costing investors money because investors time their purchases so poorly.
Arnott: Yeah. And with private equity, you have concentration on the investment side, but then you also have tremendous dispersion on the fund side, where there’s a big gap between a top-quartile vehicle versus the bottom quartile. So that could lead people to have even worse experiences.
Phillips: Yeah, terrific point.
Benz: Following up on the investor timing question, there’s this narrative that investors often fall into the fear/greed cycle where they’re chasing whatever’s been hot, selling what’s not performing well. Do you feel like that narrative is a little overstated in this industry?
Phillips: I think there’s less of that narrative today because so much money is moved to things that compensate for that, move to target-date funds, for example. I think if investors were left to their own to pick your own stocks or pick your own fund managers, then you would still have an awful lot of that going on. But I think the industry has systematically ameliorated much of that, and financial planners have encouraged that, but I don’t think you get rid of those human tendencies. We’re just wired to be susceptible to fear and greed cycles. And again, I think the responsible person in the financial-services industry works at moderating those and the less responsible players work at accelerating them.
Arnott: Before we wrap up, we wanted to spend a little time talking about the value of a liberal arts education, and you have described your twin passions as investing and literature. What would you say the two fields have in common, and why are some of the greatest investors like Warren Buffett, Benjamin Graham, Howard Marks, etc., also really prolific and talented writers?
Phillips: I think both are really rich, deep fields that you can really immerse yourself in. And I think they’re both wonderful ways to learn about the human condition, to learn about how people act, how they behave. They’re both laboratories for those. What I love about literature is that you see the world from someone else’s perspective. Someone who lives in another part of the world, someone from a different gender, someone from a different socioeconomic class, and you can see what the world looks like for them. And I think that creates empathy, and I think the world needs a whole lot more of that empathy, and investing is much the same. I mean, you can just say, these are the things that I like to buy in my own life, but to be a successful investor, you have to say, well, what if someone looks at things completely different?
What do other people like? How does the crowd behave? How do different people engage? So I think of them both as laboratories where you learn more about humanity and more about yourself, and that both of them are really about stories. One of the things I realized in the early interviews and conversations I had with fund managers is that it’s really easy to make things complex and to get lost in the weeds. And some of the worst fund managers were the ones that had the most complex strategies, and they just get so in the minutia, and they would lose sight of what they were doing. And then I would think about reading Warren Buffett’s words or seeing John Templeton interviewed on Louis Rukeyser’s show, and they would talk about the market in just such basic, straightforward ways that really resonated and made sense. And again, it made me realize that it’s about storytelling.
It’s about keeping to your story, understanding what your story is, what are the lessons that you can extract out of all of this minutia, and that the wise ones are the ones that can craft the stories and do that better than those that just get lost in the plot and get enmeshed in the weeds.
Benz: What advice would you like to pass on to the next generation of investors or young people just getting started in their careers?
Phillips: I would certainly just encourage people to invest aggressively early on, just to live within your means, and make investing a permanent part of your life. Just move that money out of your portfolio. I see too many young people, they get out, and they immediately want to live in the hottest section of town. They want to have a nice condominium. They want it to be immediately furnished. I say earn those treats over time. They’ll mean more to you over time and discipline yourself by systematically setting aside a healthy amount of your income because really what you’re doing is behaving like a responsible adult when you do that. You’re planning for the future. You’re recognizing that not everything will always go your way. You’re going to have difficult time periods. You need to prepare for them, and you need to make sure that you can withstand them.
And then the more you do that, then later in life, the more opportunities you’ll have to explore. And early on, you’re just very focused on making a paycheck, getting a living, learning about yourself, finding out how you fit into the broader world, but do that in a disciplined fashion and be setting aside for the future so that you’ll have even more opportunities when you get to a later stage in your life. And again, to me, that’s what investing is about. It’s a means to an end, and if you do it well, it’s a way of enhancing and expanding your opportunities because you’re operating from a more secure base.
Arnott: Don, thank you so much for talking with us today. We had a great time talking with you, and I know both Christine and I really appreciate the opportunity to learn from you over the years. And I feel like we’ve both learned so much about how to think about investing and write about investing from you.
Phillips: Thank you so much. We’ve come full circle because I learn so much from you guys now these days, and you both have made huge contributions to Morningstar, and I learn constantly from this podcast. So thank you for all the things that you’ve both done to contribute to the industry.
Benz: Thank you so much, Don.
Arnott: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts. You can follow me on social media at Amy Arnott on LinkedIn.
Benz: And at Christine Benz on LinkedIn or at @christine_benz on X.
Arnott: George Castady is our engineer for the podcast. Jessica Bebel produces the show notes each week, and Jennifer Gierat copy edits our transcripts. Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at thelongview@morningstar.com. Until next time, thanks for joining us.
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