A seasoned analyst opines on active fixed-income management, private debt investments, and the evolution of an asset class.
Our guest this week is our colleague, Eric Jacobson. Eric is a senior principal for fixed-income strategies on Morningstar’s Manager Research team. He focuses on a variety of taxable, tax-exempt, and nontraditional managed strategies. He covers some of the key asset managers, he publishes thought leadership, and he is a member of the Morningstar Medalist Ratings Committee. Eric joined Morningstar in 1995 as a closed-end fund analyst and also had a stint on Morningstar Indexes, where he helped launch our original Bond Benchmark Suite. Before Morningstar, Eric worked at Kemper Financial Services. He is also a proud graduate of the University of Wisconsin-Madison.
“Why the Bond Market Is Fertile Ground for Active Management,” by Eric Jacobson, Morningstar.com, Aug. 28, 2025.
“6 Critical Lessons for Bond Investors,” by Eric Jacobson, Morningstar.com, Dec. 26, 2023.
“How to Measure Your Fund’s Liquidity Risk,” by Brian Moriarty, Morningstar.com, Oct. 21, 2025.
“New Ratings Reveal Challenges for Semiliquid Funds,” by Bryan Armour, Morningstar.com, Nov. 12, 2025.
“Eurozone Debt Crisis: Causes, Consequences, and Solutions (2008-2012),” by Daniel Liberto, Investopedia.com, Sept. 29, 2025.
“Automotive Industry Crisis of the 2000s,” by Kerry Skemp, ebsco.com.
“When It Comes to Bonds, Don’t Be a Hero,” by Christine Benz, morningstar.com, Oct. 6, 2025.
(Please stay tuned for important disclosure information at the conclusion of this episode.)
Dan Lefkovitz: Hi and welcome to The Long View. I’m Dan Lefkovitz, strategist at Morningstar Indexes.
Our guest this week is our colleague, Eric Jacobson. Eric is a senior principal for fixed-income strategies on Morningstar’s Manager Research team. He focuses on a variety of taxable, tax-exempt, and nontraditional managed strategies. He covers some of the key asset managers, he publishes thought leadership, and he is a member of the Morningstar Medalist Ratings Committee. Eric joined Morningstar in 1995 as a closed-end fund analyst and also had a stint on Morningstar Indexes, where he helped launch our original Bond Benchmark Suite. Before Morningstar, Eric worked at Kemper Financial Services. He is also a proud graduate of the University of Wisconsin-Madison.
Eric, thanks so much for joining us on The Long View.
Eric Jacobson: So glad to be with you. Thanks, Dan.
Lefkovitz: Absolutely. So, you recently hit your 30-year tenure mark at Morningstar, not to age you. And looking forward to getting some historical perspectives, some reflections, what’s changed, what hasn’t, in fixed-income investing, and the mutual fund world. Let’s kick off by talking about a paper that you recently published. It feels like something of a magnum opus: The Bond Market Is Fertile Ground for Active Management. I’ll try not to be offended as an index guy. But maybe you can just talk about the impetus, why you wrote this paper.
Jacobson: Well, it’s interesting because you’re joking about the index thing, but I was trying to be kind of careful with the title because I wasn’t trying to say that indexing is not good. But what brought me to write the paper is that I think over the last several years as stock investing it’s become more and more popular for investors to use indexing on the stock side. I think a lot of people don’t really pay that much attention to bonds. They don’t understand bonds as well. And so, there’s, I think in certain circles, this notion that, well, if indexing is great for stocks, it must be the way to go with bonds as well. And the factors are just pretty different.
I think the way that the bond market works is fundamentally very, very different than the way the stock market works. And there are reasons that it makes a lot of sense to use active management sometimes, a lot of times, depending on what you’re doing. And I really just wanted to touch on that because I felt like it hasn’t been part of the conversation. You joked about it being sort of a magnum opus. Well, a lot of these things have been sort of bubbling up inside me for a long time. I never really got a chance to write about one place together. And so, I decided to sit down and do that.
Lefkovitz: And you note in the paper that the success rates for active managers in fixed income are a lot higher than for active stock-pickers.
Jacobson: They are. I hesitate to say, this is the data, and this is how it is, because I think there is a tendency to try and do that to prove a point. At any given time, you will find that there are going to be trailing periods where it looks much better for active or it looks better for passive. There are underlying reasons for that that I kind of get into in the paper a little bit in terms of the way that indexes are concentrated and what have you. But the fact is that if you are not charging too much money and you have good, competent and not overly aggressive management on the bond side, generally speaking, you can outperform indexes reasonably well over periods of time as long as you’re dealing with areas of the bond market that have inefficiencies. The more inefficient the parts are, the super highly liquid parts, like the Treasury market or what have you, a little bit closer to stocks in terms of the way they operate, a little hard to beat, but it’s definitely doable.
Lefkovitz: So, the traditional argument that I think a lot of our listeners will be familiar with is that whereas stock indexes are dominated by the most successful companies, the biggest winners, on the bond side, bond indexes are dominated by the most indebted. You do mention this argument in the paper, but it’s not central to your argument, it seems.
Jacobson: Right. It’s a key point and I think it also depends on where you are in different corners of the bond market and how it works. But it really is a truism across the board in the sense that the more debt the underlying entities take on, there’s going to be some sort of additional risk in there and they do wind up dominating indexes.
It’s not the central reason, though. The central reason that I think it’s important to understand that active investing in bonds can work well is that overall the bond market is extremely fragmented. It’s got multiple sectors and subsectors. One thing I would just say is a cornerstone to the point is this: when you look at stocks, we’re generally talking about common stocks, right? A common stock is a common stock is a common stock. And what I mean by that is in terms of structure. It is the sort of base fundamental unit of ownership for a public company. And yes, there can occasionally be little tweaks and differences in some things. But generally speaking, it’s the same thing.
Bonds, even from the very same company, can have dozens of varieties, even more potentially depending on the banks and so forth sometimes. So even within the same sector and segment, just to say corporate bonds, you can have dozens and dozens of different things going on from one bond to the next in terms of whether it’s a call feature or some other issue that even affects the credit. And so, you can’t just go to the market and say, I want a bond from that company expecting it to be the same as any other bond from that company. You can do that with a stock. And when you do, it’s very easy. You know what you’re getting. People know about situations where you’re talking about milliseconds of trading to get efficiency. It doesn’t work like that with bonds at all. Because in order to be a competent buyer or seller of a bond, you need to know a lot about it. You need to know all of its features. You need to know everything there is to know about the credit. And that’s just an entirely different situation.
Lefkovitz: You talked about inefficiencies in the bond market and its fragmentation. What do you see as some of the most powerful levers that active bond managers can pull?
Jacobson: So, it’s an interesting way to put the question because in terms of power, if you’re talking about outperforming over long periods of time, it’s almost like the turtle and the hare sort of question in the sense that to be a really good bond manager over long periods of time, the best thing you can do probably is try and find things to do in the marketplace that are what we might call structural trades, areas of the bond market that are generally either inefficiencies that are common to that area. Because of some of the things I talked about, whether it’s areas that investors tend not to go to, for example, there are a number of parts of the bond market where the securities are very complex along the lines of what I mentioned a minute ago. That’s especially so in parts of the mortgage market. What that does is it limits the audience for those securities because your average individual investor is not going to be buying them, whereas individuals trade stocks up and down all the time. You’re not going to want to do that with a lot of these kinds of bonds.
So, when there’s less of an audience, when the bond issues themselves, sometimes might be a little smaller. And so not only do you have something that’s very different, but you have a smaller pool and a smaller set of investors, it’s possible to find things that are a little bit cheaper than you would expect them to be just based on those factors. And if you know where to look, you can actually do that repeatedly. You’re not going to make a ton of money overnight, but that’s not really the idea. The idea is if you do this consistently, you can pick up a good amount—we think of it in terms of spread usually how much you’re going to make over a treasury bond, for example, in terms of yield. But there are lots of ways to do that. And you chug along over time.
I think that a lot of people think that the way to do that—the big levers that you mentioned have to do with managing your interest rate sensitivity and trying to get out in front of a market where you expect interest rates to start rising. It’s possible to do that and you can have success periodically, but over long periods of time, that’s very, very difficult. So, making those big market decisions is a lot harder to do consistently over time. And so, my whole story here really is about the fact that these inefficiencies give you an advantage of slow and steady, take advantage of them and do it over long periods of time, don’t cost too much while you’re doing it, and you can outperform over long stretches.
Lefkovitz: And one thing that caught my eye in the paper, you talk about how the toolkit for bond investors has expanded in terms of using ETFs and using swaps. Can you talk about that?
Jacobson: Sure. So, I think that the closest thing that the average investor might have a sense of understanding is stock options. And the key to that, of course, is that if you have a stock, let’s just say IBM—we’ll use an old one there—and you have options on IBM, the idea is you can get market exposure in one way or another, whether it’s long exposure where you’re exposed to the stock going up and down or short exposure where you’re going to get the opposite effect. You can do that with options. And so, there’s multiple ways really.
You have similar things in the bond market except the menu is very wide. So, you do have options, but like in the mortgage market, for example, there are forward contracts. People perhaps have heard of credit default swaps. There are all kinds of credit default swaps. And some of them are indexed in ways. Some of them are individual names. The bottom line is, is that for any different part of the fixed-income area, you might have, for example, an ETF that focuses on that area. You might have futures contracts that can get you exposure to that area. There may be options. And down the line, there are options on swaps and there are things like that.
And the reason that that’s useful to understand is that a lot of those markets can be dislocated even if by a little bit now periodically. And sometimes there are structural market reasons. There are all kinds of reasons that this might happen that really do generate some sort of inefficiency. So, for example, some of the big, well-known bond managers that do a lot of business in bonds will often, for example, make a decision whether they’re going to buy the bond or they’re going to use what we would call a synthetic, like a derivative, like a credit default swap to either get exposure to that bond or not. And a lot of times they’ll just be making that decision as they go along based on whether one looks cheaper than the other, which happens quite a bit. And I think that can be scary to some people, especially when you start throwing around the word derivative. But there are ways to use derivatives that are not especially dangerous. And this is one of them where you’re really just controlling your risk, but you’re just trying to take advantage of the inefficiencies in the marketplace. As you alluded, that’s actually a pretty good strategy.
Lefkovitz: You mentioned a number of historical case studies, the euro crisis in 2011, automobile debt in the early 2000s, that resulted in distortions in the market. Can you talk about those and the implications for indexes and active bond management?
Jacobson: So, this is where the question about indebtedness and indexing comes in. The point isn’t necessarily that you shouldn’t index, but it’s important to understand that especially with fixed income—you mentioned right at the get-go, when you’re looking at stock investing, you’re really, in a sense, putting chips down on the American economy or the global economy, if you will, and the stock market, because you expect business to be successful over long periods of time, you expect it to grow. And the idea behind owning stocks is to get exposure to that underlying economic growth engine that drives the value of companies up.
Well, in the bond market, the first thing to remember is when you just start and you move right over the bond market, you’re really just talking about corporate bonds. But the fact is, is that you have government bonds as well. You’ve got securitized bonds, which focus a lot on the mortgage market. And all of these areas are different than stocks because, as you alluded, they’re a form of debt, indebtedness.
And so, you asked about the Europe situation and the automakers. The automakers are a really good example because you had a period of time, early in the 2000s, when automakers and suppliers and so forth were becoming very, very indebted for various reasons. And within the corporate bond indexes, they started to take up a larger and larger chunk of exposure. Now, if that were to happen in a stock index, you might argue, well, is the market overvalued or not? But the idea would be it’s happening because they’re doing well. And whether it’s growth or anticipated growth or what have you, whereas the reason that these companies became larger exposures in bond indexes is they were borrowing and borrowing and borrowing more money.
And if you look at what happened at different periods, you’ll find that it doesn’t always happen this way, but if you look at GM and Ford as examples, they became very, very indebted. And eventually they both filed for bankruptcy. And that was bad for the indexes. And the point there really is, is that if you’re just getting blanket exposure to the market, you’re leaving yourself exposed to those kind of dynamics. And it’s sort of the opposite thinking of if you’re going to do it with stocks. And the idea, again, it’s not necessarily you don’t ever want to be exposed to indexes, but if you’re an active manager and you’re choosing among corporate borrowers as an example and you’re building a corporate bond portfolio, and you see that the auto companies, as an example, are really starting to come under strain, they’re borrowing more money, they’re becoming more indebted, they’re more heavily leveraged.
Those are not bonds you’re going to look for. In fact, you’re probably going to want to minimize your exposure to them in some way or another. And that’s sort of a natural economic decision there. And that makes a big difference and the kind of thing ideal to try and avoid if you can. And the key thing there is, when you look at some of these other examples, you mentioned Europe at one point, Greece became very, very indebted. And if you were in a European government index, for example, you’re getting much more exposure to Greece as you go along because they are becoming more and more indebted. And it seems like sort of an obvious thing, but you don’t want that to happen.
Lefkovitz: You also talk about the surge in Treasury issuance after the 2008 financial crisis. What sort of implications did that have?
Jacobson: So, this is a tricky one because I think a lot of people start to think, they talk in terms of bubbles and it’s a whole different conversation when you get to Treasury bonds because the issuance of Treasury bonds and the price levels are based on much bigger picture issues with the economy and government policy. But the fact of the matter is, is that when—and other things have happened since then too—but when the government starts to borrow more and Treasuries take up a bigger, bigger chunk of the market, especially if the government is borrowing at longer maturities, that literally changes the face of “the market.” And that can be a very big deal to bond investors because over the course of decades, if you think, well, I’m going to own these bonds, I’m going to own bonds for stability or at least some sort of hedge against what’s going on in stocks. But you generally have an idea, this is how much volatility I’m willing to accept and this is how bond indexes generally look. And so, I’m going to try and get that kind of exposure.
Well, at times during which either the government has borrowed a lot more and the government bonds have taken up larger chunks of the indexes, or we’ve also seen cases where corporate borrowers have started borrowing at the longer end of the maturity spectrum, it has literally changed the face of the entire “bond market” as it’s measured by indexes. And we’ve gone through a period of time where if you just look at the bond market as a whole that takes into account those large markets—the Treasury market, the corporate market—it’s more sensitive to interest rate risk now than it was just a few years ago. It’s gone up and down a little bit since the financial crisis, but it really came together a lot eventually when the Treasury market grew, the corporate market grew and shifted to longer maturities. And those took over in terms of the flavor of the index being a lot more—when I say the index I’m really [talking about] indexes that cover the broad bond market having much more interest rate sensitivity.
Lefkovitz: Our colleague Christine Benz, the anchor host of this podcast, wrote an article recently about how investors seem to be taking a really tactical approach to fixed-income investing, swapping in and out of cash, taking bets on interest rates. Yet the investor return data show that they haven’t done a great job of timing their purchases and sales. Why do you think that is?
Jacobson: It’s just really, really hard to get the timing right under any circumstances. Back in the ‘80s and early ‘90s—especially because you had had interest rates get to really long extremes during the mid-80s, for example, late ‘70s or late ‘80s—there was a sense that you could do this. You could bet against interest rates, and so on. There are all kinds of reasons it became a lot clearer in the mid-90s. For example, a lot of institutional investors said, you know what, this is not a great thing to do because if you’re wrong and you bet against interest rates too strongly, the payoff isn’t good enough on the upside and it can be really bad on the downside. It’s very hard to do it well consistently.
There have been a few managers over the decades that have done reasonably well with it. Very, very, very few. One of them was Bill Gross at Pimco. He hasn’t been managing money publicly for about 10 years. But even he made mistakes sometimes. The thing that a lot of people didn’t realize is he did it in a pretty measured way, and it wasn’t the only lever that he was pulling in terms of how to manage bond money, even though he had a big reputation for making good interest rate bets.
Beyond that, it’s not something that you can really do well consistently over and over again over long periods of time, certainly when those bets are bigger. I’m not going to say it’s like predicting the weather. There’s a little bit more to it than that. But there’s lots of reasons that interest rates move back and forth, and it’s not always that easy to sense what those are going to be. And I jumped right into that explanation. I know you were talking about going in bonds and cash, but that’s really what a lot of people are focused on is, are interest rates too low, are the words they’re going to go up? It’s also very common—we don’t hear much about it lately—but it’s common for people to try and tie in the high-yield bond market and jump in one month, jump out the other month, and so on. But as you alluded, it’s very hard to do that consistently, because ultimately, what you’re dealing with are market dynamics and trading dynamics that may not necessarily be anchored in anything super fundamental at any given moment. They may have a lot to do with market temperament and swings and expectations. Doing that is more of speculation than it is investing in some ways.
Lefkovitz: Well, 2022 seems to be an example. It looks obvious in retrospect. The yields rose dramatically. The Fed and other central banks were responding to inflation by jacking up interest rates. But it seems to have caught a lot of people off guard.
Jacobson: Yeah. It’s a very, very difficult period to look back on because what sometimes happens in bond markets is you can get to what we think of as kind of extremes. For example, when interest rates get very low, and start thinking, well, it’s obvious they’re going to go up and it’s going to create problems or it’s going to be a crash, and so on. The problem with bond markets, especially when you are talking about those that are anchored toward government bonds, is that sometimes those trends are structural in a sense. They happen for a reason that doesn’t change for a very long time.
So, for example, after the financial crisis, almost immediately in fact, or during the financial crisis, people were already talking about how indebted the government was going to get and how low interest rates were going to be and how it was going to turn into a bubble. And we had to really be worried about interest rates rising very shortly after the financial crisis. In fact, it generated so much angst and so forth, there were whole new kinds of funds that were created to try and take advantage of that by saying, well, we’re going to keep interest rates low. We’re going to do everything else, but we’re going to protect you from rising interest rates because inevitably they’re going to spike up. Well, that inevitability lasted for years and years. There were reasons that interest rates stayed low for a very long time after that. And knowing exactly when they’re going to spike up is very difficult.
And so, if you had positioned your portfolio, as an example, after the financial crisis, expecting that interest rates are going to spike at any time—in other words, we’re going to have a bear market like we had in 2022—you would have sat on the sidelines for years. And it would have cost you, not just in terms of, depending on how you did it, it would have cost you in terms of the opportunity cost. But also in a bond world, you can actually pay in a sense if you’re buying bonds and then hedging out the interest rate risk, that’s costing you.
That can happen with credit markets, too. Now, eventually credit markets, when they do have sort of a bubble situation like we’re talking about, those are a little more likely to pop because they’re a little more drawn by market forces rather than big, big economic forces and central bank decisions. But even then, bubbles can last a whole lot longer than people realize. And there’s always a risk of staying out too long. I think the problem with 2022 is that you hit a couple of things all happen at one time. Covid really, really changed the dynamics of everything because of all the central bank intervention and so forth.
So yes, can we look back and say, well, it should have been obvious that this was going to happen? But the problem is you’d have to really, really know an awful lot about inflation. You would have had to been right. And you would have to really, really know how soon it was going to happen. So yeah, after the financial crisis, were you right in thinking that eventually interest rates were going to have to go up? Yeah. But it took, I don’t know, more than a decade, a decade and a half? So, that’s really hard work.
Lefkovitz: So, let me ask you this, Eric: Do you think that going passive in fixed income is a mistake for investors?
Jacobson: I don’t. I think if you are looking for some sort of core exposure to especially very high-quality, highly liquid parts of the bond market, and you’re not going to pay very much at all because hopefully most index funds are going to be pretty cheap, you can get a pretty good exposure that way and not really give much up. For the most part, though, you’re going to be talking about Treasuries and high-quality corporate bonds and maybe the broad mortgage bond market. But there are a lot of things that are going to be left out if you just buy your plain-vanilla core market exposure that you’re not going to get exposure to in the bond market. A lot of people may have heard of CLOs, they’re collateralized loan obligations. There are other parts of the bond market that—and I’d have to go down a long list on the mortgage side of things that have become more and more popular with active managers but just don’t really exist in the big indexes. And even in sort of nichey things, it’s very hard to get index exposure to them.
I mentioned those. There are nonagency mortgages. They are not anything like they were 15 years ago after the financial crisis. There are different kinds now that are, I’m not going to say they’re automatically safer because there’s all kind of risks that can develop, but they give lots and lots of choices and opportunities to active managers that you’re just not going to get in a core index.
So again, I’m definitely not against fixed-income indexing at all, but you certainly want it to be cheap, and you want to recognize that you’re not going to have the breadth of market that you might get by being more active. And you also want to recognize that because of the way the bond market has evolved since the financial crisis in the last several years, you may be taking on more interest rate risk than you thought you were because say five, 10 years ago, the bond market was probably a little bit less rate-sensitive than it is today. So, you just want to make sure you understand that or if you’re working with a financial planner that they’re taking that into account.
Lefkovitz: Well, let’s shift gears. We’ve talked a lot on this podcast about the rise of private markets and how more capital formation is happening outside of public stock and bond exchanges. We’ve talked a lot about the equity side, but I wanted to ask you about private debt. I imagine this is an area where you’ve seen a lot of change over the course of your career. Maybe first you could just talk about the nomenclature of the terminology. People use private debt; people use private credit. How do you like to think about these terms?
Jacobson: Sure. Well, it’s a really apt question because the term, if you look in the materials and you talk to people, you find out that really the term private debt really only means, in the grand scheme of things, that a piece of debt was originated or issued by a nonbank actor, I’ll say, but really a nonbank institution. Some sort of other party. And so, the big firms that people are familiar with from the private equity space, for example, like Blackstone and KKR and Carlisle, these firms are not banks, but many of them are involved in helping essentially loan money to companies and selling that debt to other people, for example. That is in and of itself the word private debt.
But when you get down below that, there are different kinds. You mentioned the difference between private debt and private credit. Well, generally speaking, private credit, especially in today’s world, really just normally means what they will call direct lending to middle-market companies. In other words, borrowing that is set up by these companies on behalf of—when I say these companies, these big money managers, private equity companies also—to lend money to smaller and midsize companies rather than usually the very largest and that kind of direct lending. And when that’s done, that kind of debt is usually some sort of private placement, not just privately issued, but privately placed, which means it can only be bought and sold by certain investors. Generally speaking, depending on how it’s structured, it can’t be easily resold. And it usually is the kind of thing that once you buy it, it sits on your balance sheet or in your fund and it doesn’t move after that. So, it’s going to be very illiquid.
Now, the trade-off is you should make a lot more money in exchange for that. There are other parts of the private debt market, though, that aren’t technically thought of as private credit. These have become very big quietly in the last few years–—you might hear the term asset-backed finance. And basically, what that is, is a way that they find to take a pool of assets that are going to generate cash flows and build a security around it. Not entirely unlike mortgage securities that you’ve heard about, maybe asset-backed securities, commercial mortgage-backed securities. The only difference is, they’re done in this private space by a nonbank actor and they may be sort of specialized, depending on what they’re investing in. But I suspect people have heard over the years that at one point, David Bowie securitized his record catalog and the royalties from that. Well, that is a form of asset-backed security and that is the kind of market that we’re talking about here. It’s sort of a customized asset-backed finance market.
But you’re also finding creative ways to do that with very, very large pools of assets. So even then, when they create these asset-backed finance deals, generally speaking, a lot of these, they put them together, they do it privately, but then they securitize it, which means they put those legal wrap around it and they make it easier to trade. And those tend to be a lot more fungible. That’s not quite the right word, but much easier to trade and more liquid than you might anticipate. When someone says private and you’re thinking of that direct lending where it’s just basically like a loan that stays in your portfolio and doesn’t move, they can be very, very different things.
Lefkovitz: Well, along with your colleagues on the Morningstar Manager Research team, you’ve been covering funds that offer exposure to private credit to retail investors. These are mutual funds, ETFs, 40 Act. I want to start by asking you about an ETF that you’ve written about with the ticker PRIV. It was a joint venture between State Street and Apollo. Can you talk about what happened there?
Jacobson: Well, this is a really good example because when they first started publicizing that this fund was coming, everybody was making a very big deal about the fact that it had private in the name. And like I said, people think of private, they tend to think of that direct private credit, direct lending. And that stuff is very illiquid. There’s not a lot of public information about it. Like I said, it can’t be easily traded among investors for contractual legal reasons. And to put a lot of that into a mutual fund or ETF strikes among people as kind of risky because if it’s not easily traded, it’s not easily priced, especially in the case of an ETF, for example, where you have potentially cash flows going in and out very quickly and the fund company can’t actually ever close an ETF, it strikes people that that’s going to be a big problem potentially. And the fact of the matter is, is that what they are doing, what they did do with the State Street ETF and a couple others that they’ve rolled out since is they have some of that private credit, direct lending that I was talking about, but they actually hold a lot more of that asset-backed finance stuff that I was referring to.
So even though some of that asset-backed finance stuff starts out kind of customized, it’s a special deal, and it’s done not through a bank and not necessarily in a publicly syndicated market that we might talk about, eventually they package it up, they securitize it. Like I said, they get industry standard identifiers for it, CUSIP numbers that we talk about. It may not be able to be sold on a one-by-one basis to an individual investor, but most stuff in big bond funds today isn’t necessarily sold that way anyway. And as long as they do it that way, they get those industry identifiers and it’s easy to trade them, they tend to be much more liquid than people expect. So ultimately, these State Street funds that I’m talking about are not nearly as risky and as illiquid generally speaking as people I think thought initially. Now, granted, they may also not be the highflyers that I think some people thought they might turn out to be also.
Lefkovitz: The team has written about something called Level 3 Assets. It’s something that investors should be paying attention to. Can you talk about what those are?
Jacobson: So, those private deals that I was talking about a minute ago that are not easily traded, they’re privately placed as well. And when I say privately placed, I mean directly to a buyer; they’re not registered with the SEC, and so on. Those are things that cannot be easily valued. And that’s really what Level 3 is all about. When we talk about Level 3, we’re talking about fair value levels. And that construct is an accounting construct—accounting standards that are set by the Financial Accounting Standards Board. Regular companies when they report their assets use this as well.
And in a very high level, Level 1 assets are things that are real easily priced because they’re exchange-traded. Level 2 assets may not be traded on exchanges, but there’s all kinds of ready inputs that you can use to price them, whether it’s looking at very similar securities, using quotes from broker/dealers, all kinds of things like that. Level 3 is something that cannot be valued with what they call readily observable inputs. And that normally means that some level of actual hand pricing, if you will, has to be done by whoever is reporting the value of that asset. And when you get to that level, you can expect that that kind of thing is not going to be liquid.
And so, this is a perfect example that you mentioned. When we look at the SSGA Fund, because that direct lending privately placed stuff almost by definition always has to be Level 3. And that’s going to be potentially the least liquid stuff. The asset-backed securities that we were talking about earlier that involve other pools of assets that are not just direct lending, but maybe the securitization of—one of the big things lately was data centers. They put the data centers in a what they call a special vehicle, if you will, and they sell interest in that to investors. That’s a kind of asset-backed security, an asset-backed finance deal. And as long as it’s wrapped up in the right packaging and it becomes easily sold, then you can put it in Level 2, and you can quote the price on a regular basis much more easily, much more transparently; you expect that to be more liquid. The problem if you’ve got some sort of fund with lots and lots of Level 3 exposure is that tells you that there’s a lot less transparency there. It also tells you that whatever prices they’re using may have to be done somewhat manually and they may not compare perfectly to the prices that somebody else would put on them. And that’s where you get that sort of stickiness of this is going to be illiquid, this is going to potentially create issues if they need to sell these, for example.
Lefkovitz: You’ve been involved in the coverage of some semiliquid funds, interval funds, and the like that don’t offer daily liquidity but hold private debt. And some of these funds have really appealing yields. Obviously, liquidity is something to pay attention to here. What do you think investors need to know about these types of strategies?
Jacobson: Well, the first level of things, hopefully, that they do wind up knowing is that many of these that we’re hearing about today are structured either as interval funds, tender-offer funds—which the two are very similar, but they have different requirements of the managers, how much they either have to or not offer you to get your money back—or some of these BDCs, or business development companies. But the most common thing that you see among them, the way that they’re sold to investors today, is you can purchase them at some periodic amount of time depending on how it’s structured. In some cases, almost anytime, you can buy them, but you can only get some of your money back at certain times, when you request it back from the company. And generally, in some cases, not even obligated to send it back to you if they’re in a crisis situation, they don’t feel they can, or they have to just fulfill, say, only 5% of the requests, I’m sorry, 5% of their assets, for example. And whether you get your money back at that time depends a lot on what other investors are asking for their money back, do they have to make decisions and give it to you, what they would call pro rata, where everybody just gets a piece of what they asked for. But the most important part there, of course, is that it’s not the same as a regular mutual fund, it’s not like an ETF, you cannot just get your money back right when you want it, you can’t just cash it in. And in some cases, you may have to wait months. If you are trying to get your entire investment back, that could take a very long time depending on how it’s structured and whether or not there are other investors trying to get their money back. That’s sort of a high-level thing that’s critical for people to understand. You just don’t want to use those as a substitute for regular mutual funds.
The other issue is a little stickier right now because there’s a lot of debate on how risky these underlying markets are. And there is a line of thinking that says, if you’re investing in the kind of private debt that we’re talking about, but it’s inside of these “semiliquid structures,” you can’t think of it the same way you do an ETF or a mutual fund. You’re just not going to be able to get your money out overnight the way you can with those—in fact, by law, by regulatory law, they have to allow you to do that. These semiliquid funds have all different kinds of rules and restrictions. You may not be able to get your money out for a month or a quarter or even longer, depending on what’s going on. So, you have to really be comfortable putting that money aside and recognizing, “I can’t think about that as emergency money in any way, shape, or form. It could take me a lot longer.”
Now, there is a line of thinking in the industry among some people that because of those restrictions, and the fact that the asset managers have so much control over when and how much money the investors get back that that creates some sort of safety with those underlying assets. The problem is, is that as we’ve seen in these markets in the past, there are unintended consequences. And so, for example, if there are other large investors that have exposure to some of these assets and they run into other problems, that can cause them to have to dump things that have an effect on this or that, and it can cause problems in the underlying markets. These underlying debt markets could wind up in much rougher shape than we expect in the wrong kind of crisis.
A lot of people are arguing that we’re in sort of a bubble now, and it’s going to be just like the financial crisis was in 2008. I’m not saying that. I think whatever we wind up having in the next several years is going to wind up being different. The problem is, is that there are things that go on behind the scenes that you just don’t understand in terms of risk and how they connect to each other. So, you’ll hear people talk about the financial crisis, even people who knew that the housing market was starting to hit a point where it wasn’t sustainable, even what the Fed and the government didn’t understand is—they did not understand how much risk was deeper, deeper, deeper into the marketplace because of the way that investors had exposure to these things. They didn’t realize how levered the banks were to each other. They didn’t realize the level of derivatives that had been written on it. And I realize that’s kind of arcane stuff and it doesn’t sound like it’s the same. And I’m not saying that it is. But the bottom line is when you have a risk in financial markets, especially when there’s fixed income involved, there are connections and what they call transmission linkages that are really, really hard to see because the information is not public. You don’t know what the relationships are sometimes between these companies.
So, I think it’s just really important to understand that, especially in areas of the market that are newer, like this huge expansion of private debt, or areas of the market that don’t have as much transparency, you always have to be ready for the possibility that something can happen that nobody anticipated. That doesn’t mean you should never take those risks, but especially in an area like this, where so much is just not transparent. That’s sort of part and parcel of this whole private concept is that when we think of nonprivate, we talk about public, we are usually talking about things that are related to the banking system and the broader economy that are more heavily regulated. These are things that the Fed and the Treasury can see more easily. And so, we saw what happened in the great financial crisis with mortgages and they had a reasonably good view of things and they still didn’t see what was coming because they didn’t understand all these under the covers, if you will—that’s not the best way to put it— but connections between things that were not easily visible to the public. Well, in this case, they can see even less because these markets are much more lightly regulated, if at all, in many cases.
Lefkovitz: But the team has assigned some Medalist Ratings to private debt-focused interval funds. Who do you think is doing this well?
Jacobson: Well, I think at this point, those that we have favored are ones we have some familiarity with them, the public has some familiarity with them, they’ve been doing it for a long time, and they’re not necessarily taking dramatic levels of risk. We’ve given positive ratings to a Pimco fund, for example. A lot of people don’t realize they’ve been involved in what are essentially these kinds of private deals for a long, long time, for years, behind the scenes. And some of it is in that asset-backed finance area as well. So even though it’s technically private because it’s involving nonbank actors, they are these asset-backed holdings that firms like Pimco and several of their competitors have been involved with over decades in terms of the securitized markets. So, they have a track record doing that well. They have the staffing; they have huge resources to manage it well. And they’re not taking what we would necessarily think of as undue risks in the way that they’re managing the money.
And I suspect as we go along here, you’ll see more and more shops and funds that we’ll think pretty highly of. But it’s going to be critical for people to understand risks because we won’t necessarily say you should never buy something because it has an X amount of risk. But you want to understand that the baseline here for these private assets is you’ve got to be much more conscious of what you’re doing. You have to make sure you’re buying it in the right vehicle, if you will. These kinds of things that have limited liquidity or limited ability to get your money out are kind of important because you don’t want to be forced to sell something if it’s not easily sold.
Lefkovitz: Well, let’s shift gears again. You’ve been at Morningstar now for over 30 years. Before coming to Morningstar, you were working in the mutual fund industry, and you said you really wanted to come to Morningstar because you wanted to work on behalf of investors. It’d be interesting to hear about some of the practices that were common at the time that gave you pause.
Jacobson: Well, it was really interesting to me as that was my first entree into the industry. And what I didn’t really appreciate was that there were different motivations for people. I was pretty young and maybe a little naive. But what I didn’t realize is that you could be an asset manager and be in that business to do it to make a living and make money, but that the outcome for your investors might not be the first thing on your mind. I think at the time, in sort of a general sense, I think depending on the kinds of firms you’re talking about, a lot of them are like, well, we’re going to deliver this service. We’re going to do it OK. We’re going to do it as well as anybody else. It may be average or a little better. And as long as we do that and we’re consistent, then we can make money, and everybody is going to be happy. We don’t need to be the best. We certainly don’t need to even be almost the best. There were firms at the time, especially I feel that they were sort of looking at it as a profitability sweet spot. They didn’t want to have star managers. They didn’t want to have to pay too much for the resources that they were using to generate money management outcomes and so forth. And they did that sort of as an economization, if you will. Just don’t overpay and keep as much of the profits as you can while you keep your investors happy enough, if you will.
It was almost mediocrity by design. I don’t mean to be too pejorative. But I can tell you that when I went through one of my trainings at one point, they said, listen, all mutual funds are the same. The only thing that distinguishes us is the service that we give. Well, a little bit of a simplification, to say the least. And that bothered me.
I can also tell you I had what I viewed as the good fortune of having worked at a shop that wasn’t necessarily a bad actor per se, but they were doing things that a lot of other companies were doing at the time in terms of gimmicky bond funds as an example. If you go back and look, this was already years ago, but there were things called option income funds. There were funds that did things like cross-hedging currencies to try and get an advantage one way or the other. And these were all things that were generally designed to generate yield, and that’s how they were sold to investors. “This fund has a bigger yield than that fund. You should buy it.” And invariably, a lot of these things blew up. And it was almost like every couple of years, they would have something blow up and then start over and come up with another gimmicky product.
And the reason that I found that so valuable is it taught me a whole lot of lessons that we don’t see these things quite as often anymore because I think a lot of people learned their lessons. But it’s a very big help to see them coming. We always talk about history not repeating but rhyming. When we start to see things where it’s clear that the interest of investors is to get a lot of yield, we know that there is almost always going to be some sort of potential for— I’m not going to say chicanery per se, but something that isn’t quite what you hope it would be. It’s not going to be best practice, for example, or it’s going to involve a lot more risk I think investors understand that they’re going to get.
So, for me, it was a really valuable lesson. And it wasn’t unique to the company I worked for. There were a good handful of them. A lot of the big names from that period of time in the early ‘90s had been doing a lot of the same things. And eventually, a lot of those practices got weeded out. But every X number of years, you get a whole new generation of people that are coming up with products, and they think they can sell them, and they start to get designs on something that is a little too clever by half.
Lefkovitz: And when you joined Morningstar, you were specifically on the closed-end fund research team. Can you talk about why closed-ends were carved out into their own team at that point?
Jacobson: Well, I think we tended to think back then, and we still do to some degree, although it’s starting to change a little bit, in terms of the delivery vehicle. So, if a mutual fund was different than a closed-end fund, it was different from a stock, and so on. We have a lot more varieties now. We have separate accounts, obviously. We have institutional accounts and collective investment trusts. As a whole, Morningstar, we’ve started to try and cover them from a research perspective more broadly and a little bit less focused on what the vehicle is and more about what the strategy is. You still have to take those vehicle things into account. But it’s helpful to understand that if a fund company, or not just a fund company, but an asset manager, they may be managing the same style, but in four different packages, that it’s helpful to understand that. And sometimes it’s helpful to understand that just in terms of, should you be buying it in this packaging or not?
So back then, I think the closed-end universe existed for decades and decades, and it really was built around, especially with bonds, about generating a lot of yield. They trade like stocks, and they generate a lot of yield, and I think the audience for them historically has been a little different because of that. And back at that time, it was the province of a lot of older investors that were comfortable and used to buying things based on yield, and we had that audience who was very specific at that time. And we like to joke that a lot of our favorite investors read it at the library. It was a very popular product on the shelves of a lot of libraries. But we really started to fold it in together with the rest of our coverage as we saw that the market was not expanding that much, and like I said, a lot of the same managers were running similar strategies in different formats.
Lefkovitz: You mentioned Bill Gross earlier. You’ve had the privilege of interacting with some great investors, some titans of the mutual fund industry. What have been some of the most memorable experiences interacting with bond fund managers?
Jacobson: Well, I like to tell people I’ve had more than one try to get me fired. I’ve been very fortunate working for Morningstar. They’ve had our back. It’s been one of the things I love about working here is we really prize that independence and research, and I don’t have to be worried about am I going to lose my job because I upset a manager? It’s not fun. It’s not fun to know that somebody is trying to get you fired, but it’s happened a number of times. So, I’ve got some of those drama stories.
But one of my favorites actually I was thinking about is that we were talking about the financial crisis, and there was a time real in the middle of it, I think it was late 2008, and I was out in California for an investment conference, and there was a fellow by the name of Dan Fuss, a legendary fixed-income investor from Loomis Sayles. And we had agreed to do an interview on camera, but we were going to have breakfast first. And this was a period of time—I think it was before the TARP had been passed by Congress. Some people may remember, I think it was about a $700 billion rescue package, and there was a period where the market was just all over the place out of fear that if they didn’t pass it, it was going to wreck the economy, and so on.
And admittedly I was young still, I had never seen anything like this before, and there was sort of a blood-in-the streets moment, and I didn’t know what to expect. We were all nervous. I had small children. And I was really anxious about the whole thing. And the funny contrast is – I was in Southern California, it was beautiful outside, there were palm trees. But I sat down to breakfast with Dan Fuss, and I’d never seen a man so giddy about the investment markets. It was very sort of a Warren Buffett moment, too. At one point, he told me he was upset because nobody would sell him anything. He was excited because he saw big names that he had been following in the corporate markets, for example, that had been beaten down in the sell-off, and he wanted to buy them. He had been waiting for these things to get cheap, and he was ready to pounce. And his frustration was, even though the prices were down in terms of how are they being marked in people’s portfolios, there were people ready to sell. It wasn’t as easy, like with stocks we talked about earlier. If nobody wanted to sell, it’s really hard to buy, or certainly in size if you want to spend millions of dollars.
But it was really an interesting, instructive moment. Here’s someone who had been through his lifetime of investing for decades and decades, and what seemed to me perhaps the most precarious time in our lives in terms of a market crash or crashing market, if you will. But he was a diagonal investor, and he was there to invest, and he was ready. He had been thinking about things very much the way he sort of, like I said before, Warren Buffett thought about the world. He was waiting for this to happen, and he was just giddy. And the contrast between that and my anxiety and the palm trees outside, in hindsight, was kind of amusing. At the time, I was a little more nervous.
Lefkovitz: Well, now you’ve got decades and decades of experience here.
Jacobson: Yeah.
Lefkovitz: All right. Well, it’s been great. It’s been really instructive hearing about your experiences and all your insights. Thanks so much for joining us on The Long View.
Jacobson: Thank you so much for having me. I really appreciate it, Dan.
Lefkovitz: 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.
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