Bogleheads® on Investing Podcast 025 – Don Phillips, host Rick Ferri (audio only)

00:00:00.000 | - Welcome to Bogle Heads on Investing podcast number 25.

00:00:14.600 | Today my special guest is Don Phillips, former CEO and a managing director of Morningstar.

00:00:20.800 | Over the last 35 years, Don has had a front seat watching and commenting on the many changes

00:00:26.280 | that have occurred in the mutual fund and advisor industries.

00:00:38.920 | Hi everyone, my name is Rick Ferry and I'm the host of Bogle Heads on Investing.

00:00:43.400 | This podcast, as with all podcasts, is brought to you by the John C. Bogle Center for Financial

00:00:49.000 | Literacy, a 501(c)(3) nonprofit organization that can be found at boglecenter.net.

00:00:57.080 | Today our special guest is Don Phillips.

00:01:00.400 | Don is a former CEO of Morningstar and a managing director who remains involved with corporate

00:01:05.800 | strategy and investment research.

00:01:08.560 | Don joined Morningstar in 1986 as the company's first mutual fund analyst and soon became

00:01:14.240 | the editor of its flagship publication, Morningstar Mutual Funds.

00:01:18.840 | He established an editorial voice for the company, and under his leadership, the company

00:01:23.360 | developed Morningstar style boxes, a Morningstar rating system, and many analysis techniques

00:01:29.000 | that are stable in the mutual fund industry today.

00:01:32.140 | This podcast is a fast-moving discussion about many topics of interest in the mutual fund,

00:01:37.440 | ETF, and advisor industries, and we even touch on federal reserve policy and cybersecurity.

00:01:44.080 | So fasten your seatbelts, here we go.

00:01:47.800 | I'm delighted to have with us today Don Phillips.

00:01:51.320 | Welcome to the podcast, Don.

00:01:52.960 | Thank you, Rick.

00:01:54.640 | Don, you have quite an interesting history.

00:01:58.160 | You joined Morningstar back in 1986 as the first mutual fund analyst, and ironically,

00:02:05.000 | I was just getting into the business around that time.

00:02:07.800 | Can you tell us a little bit about your background?

00:02:10.600 | I had started investing back when I was a teenager.

00:02:14.040 | My dad bought me 100 shares of the Templeton Growth Fund for Christmas one year, and then

00:02:18.120 | he sat me down on Friday night when Wall Street Week with Louis Rukeyser was on, and John

00:02:22.280 | Templeton was the guest host.

00:02:24.280 | And I was just so impressed.

00:02:25.280 | It's like, here I am, this little paper boy, and here's my personal money manager on national

00:02:29.240 | television.

00:02:30.520 | And it just really was amazing to me.

00:02:32.000 | It just sort of opened up a world for me, and for a long time, I thought of Templeton

00:02:36.000 | as a role model.

00:02:37.000 | And I think it was only later in life that I realized that the real role model was my

00:02:40.760 | father.

00:02:41.760 | And it was for me that investing was something that he did as a responsible adult, and it

00:02:45.400 | was something that I could do.

00:02:47.080 | So I had an early introduction to funds, and really thought it was a sensible way to invest.

00:02:52.520 | I studied economics at college and completed all my coursework in economics, but then switched

00:02:58.280 | over to English literature and was pursuing a master's degree in literature at the University

00:03:03.280 | of Chicago when I decided to sort of flip things around.

00:03:07.280 | I was thinking that I'd become a college professor, but be an active investor on the side.

00:03:11.680 | And I decided to flip that around and say, "Well, why don't I get a job writing about

00:03:14.920 | researching investments, hopefully mutual funds, and then read the great books on the

00:03:20.160 | side?"

00:03:21.160 | And Joe Mancedo ran an ad in the Chicago Tribune that said, "Wanted Mutual Fund Writer."

00:03:25.040 | And I sent him an impassioned letter saying, "This is exactly what I want to do with my

00:03:28.760 | career."

00:03:29.760 | We came in and talked for an hour about John Templeton, and two days later, he called up

00:03:33.000 | and offered me the job.

00:03:34.000 | >>Corey: Now, if I recall a story about Joe doing mutual fund analysis at his kitchen

00:03:40.320 | table, is that-

00:03:42.240 | >>Steven: I joined Morningstar after Joe had moved out of the apartment, so I never had

00:03:45.600 | to deal with the dirty socks on the floor, things like that.

00:03:48.360 | He was in the Monadnack building in Chicago, had just sort of moved in there.

00:03:51.920 | But he'd started the company in '84, so he'd been around for about 18 months to two years

00:03:56.760 | before I joined.

00:03:57.760 | And he was already putting out the Mutual Fund Sourcebook, which had a tremendous amount

00:04:00.880 | of mutual fund data in it.

00:04:02.760 | It had holdings.

00:04:03.760 | It only covered equity funds.

00:04:05.080 | He wasn't quite sure how it was going to cover bond funds at the time, and it didn't have

00:04:08.720 | any analysis of the individual funds, but it did have the star rating.

00:04:12.560 | Now, that predates me.

00:04:14.360 | But I was hired for a second publication that Joe wanted to do, and it's the one that you

00:04:17.680 | are probably more familiar with, and it had the one-page reviews of funds.

00:04:21.040 | It had a lot of data and graphs-

00:04:22.960 | >>Corey: Right.

00:04:23.960 | Right.

00:04:24.960 | Yeah.

00:04:25.960 | Right.

00:04:26.960 | >>Steven: And I was hired to write that text, to sort of interpret the data, to call up

00:04:27.960 | fund managers, to get additional information, and to give an investor kind of a fuller picture

00:04:32.800 | of what they needed to know about that fund to decide if it was appropriate for them or

00:04:36.960 | not.

00:04:37.960 | >>Corey: I recall the first job I had in the industry, I was working at Kidder Peabody,

00:04:43.360 | and we used to begin to get these paper editions of Morningstar printed on newspaper-type print,

00:04:52.400 | and they were fascinating to go through them.

00:04:54.800 | There was such great information.

00:04:56.440 | Eventually, this continued to grow, and at one point along the way, you got to meet Jack

00:05:03.040 | Bogle.

00:05:04.040 | Can you talk about your relationship with Jack?

00:05:05.840 | >>Steven: Well, Jack became an early and ardent supporter of Morningstar, and he was talking

00:05:10.360 | about it in the press before I ever met him.

00:05:12.400 | I remember one early quote he said, something along the lines of, "I bow to no man in my

00:05:16.440 | respect for Morningstar," and I think what he realized early on is that we were coming

00:05:20.440 | at investing from the same point of view that he did, and that we believed if the investor

00:05:24.680 | doesn't win in the long run, everyone else in the process has failed.

00:05:27.920 | It all has to be about investor success and helping people meet their goals.

00:05:32.240 | It's not just about making a lot of profits for the asset management company or for the

00:05:36.440 | person selling the funds.

00:05:37.920 | It's about the investor.

00:05:38.920 | I think Jack also realized that we were shining a light on the playing field, and that the

00:05:44.200 | more it became a clear, well-lit, even playing field, the more the cost advantages that he

00:05:50.560 | had at Vanguard and the superior investment product would win out over time.

00:05:56.840 | He was a big early supporter of ours, and I've always appreciated that, but it's simply

00:06:01.080 | because we had philosophically the same mindset about doing what's right for investors.

00:06:05.680 | >>So you had to review all these active funds.

00:06:09.640 | That was your first job, and write about them, and really get into the nitty-gritty detail.

00:06:13.920 | You were truly a mutual fund analyst, and probably one of the first ones out there,

00:06:21.600 | but you eventually started to have an affinity for index funds.

00:06:28.440 | Can you talk about how that "aha" moment occurred?

00:06:31.880 | >>Well, I don't know that it was an "aha" moment.

00:06:34.760 | We were always just looking for things that are good for investors.

00:06:38.600 | Index funds clearly were good for investors.

00:06:40.800 | It's broad-based diversification, low cost.

00:06:44.360 | I should back up and say maybe what Jack Bogle would call a traditional index fund is good

00:06:48.520 | for investors.

00:06:49.520 | Later on, we saw some bad behavior under the index tent.

00:06:52.440 | >>Absolutely.

00:06:53.440 | >>At one point, there were scores of index funds that had turnover ratios of more than

00:06:57.440 | 100% a year, or expense ratios of more than 1% a year.

00:07:01.000 | As Jack Bogle would say, the whole case for indexing falls apart if it's not prefaced

00:07:05.320 | by the words "low cost" and "low turnover."

00:07:09.400 | They were broad market indexing.

00:07:13.120 | Indexing just became more and more compelling, interestingly, as active management became

00:07:16.800 | better.

00:07:17.800 | That's sort of the paradoxical part about it.

00:07:21.000 | For one segment of the market players to better the averages, you've got to have some other

00:07:26.880 | group of participants who are underperforming.

00:07:29.720 | For years, those underperforming participants that allowed active managers to be above average

00:07:34.680 | were the individual investors, or the shoot-from-the-hip stockbrokers who were advising individual

00:07:39.840 | investors.

00:07:40.840 | These individual investors going out trying to play the market oftentimes had very poor

00:07:45.400 | results.

00:07:46.840 | You may recall back then, they used to talk about this thing they called the "odd lot

00:07:50.000 | theory."

00:07:51.000 | >>Oh, yeah.

00:07:52.000 | >>That meant when the volume of small trades, odd lots being buying securities in less than

00:07:56.320 | 100 share blocks, when the volume of that went up, it meant that individual investors

00:08:00.280 | were piling in the market, and that was a sign of a market top.

00:08:03.920 | For a long time, you did get superior performance among active managers because you had this

00:08:08.440 | underperforming group of individuals.

00:08:11.600 | What happened over time is those individuals got smarter.

00:08:13.360 | They said, "Hey, we're tired of being the suckers here.

00:08:16.560 | We're not going to buy individual stocks.

00:08:18.240 | We're going to start buying funds."

00:08:20.200 | Now all of a sudden, it was only professionals who were really dominating the market.

00:08:24.720 | Even in the early days, you still had a lot of mutual funds, active managers who regularly

00:08:29.600 | outperformed the market.

00:08:31.700 | It seems to me, and you can't prove this, but where that advantage went away was when

00:08:36.040 | regulation fair disclosure went out.

00:08:39.120 | No longer did the big East Coast shops get first crack at corporate management or maybe

00:08:44.640 | get little insights.

00:08:45.640 | Once it came out that corporations had to give information out to all participants at

00:08:51.120 | the same time, that sort of structural advantage and superior performance that you saw from

00:08:55.600 | some big East Coast shops year after year after year started to go away.

00:09:00.440 | Then you also saw as more money went into mutual funds is that across the board, the

00:09:04.480 | caliber of the asset management went up.

00:09:07.720 | I think the CFA program had a huge amount to do with this in that it started educating

00:09:11.720 | more people.

00:09:12.720 | Analysts, even at small fund shops, became very sophisticated and much better at what

00:09:19.000 | they were doing.

00:09:20.000 | More importantly, maybe they were also being trained in the same methodology.

00:09:23.520 | Now, all of a sudden, when you've got the market dominated by professionals who have

00:09:28.600 | access to the same information and are using the same mindset to analyze securities, active

00:09:35.400 | management became more and more homogenous.

00:09:37.200 | In my mind, that's what really set up the stage for the rise of passive investing because

00:09:43.200 | passive investing is simply about keeping your costs down, keeping your transaction

00:09:46.240 | costs down, keeping your expense ratios down.

00:09:50.400 | When you're looking at a homogenous group, it's the low cost provider that's going to

00:09:54.760 | be the winner there.

00:09:56.680 | The great irony is that passive has succeeded largely because active got better.

00:10:02.560 | >> I went through the CFA program and it's true that it was a very good program.

00:10:07.520 | It produced a lot of good analysts and money managers who were all basically doing it the

00:10:13.640 | same way.

00:10:14.640 | >> Before, you had really big shops which had training programs and their analysts all

00:10:19.400 | became maybe the equivalent of today's CFAs, but then you had a lot of mom and pop shops

00:10:23.720 | and people forget what a cottage industry, the fund industry was 20, 30 years ago.

00:10:28.480 | There were all of these small shops and maybe their main stock picker, maybe someone just

00:10:33.040 | with drawing out little hand charts and going to the newspaper every day and writing down

00:10:37.240 | prices and then trying to do head and shoulder diagrams or something like that.

00:10:41.540 | It was not nearly as sophisticated an industry 30 years ago that it is today.

00:10:47.300 | It was as the industry grew in sophistication and became more homogenous that the case for

00:10:51.640 | indexing became even more compelling because it was harder to find consistently superior

00:10:56.280 | managers because that pocket of underperformers started to be chipped away at.

00:11:02.320 | >> Interesting that you talk about the odd lot trend line and such where the number of

00:11:06.140 | odd lots going up, therefore more speculators in the market, that it signals in some way

00:11:12.960 | a market top.

00:11:14.400 | I recall the number of day traders in the 1990s who you ran into them and they were

00:11:20.300 | quitting their day job to become day traders and we were all saying, "This has got to be

00:11:24.240 | near a market top."

00:11:25.240 | Well, I know it's funny, but you know what, I'm seeing that right now, seeing it right

00:11:30.280 | now.

00:11:31.280 | You've got these Robin Hood traders, you've got people who I see on Twitter who just are

00:11:35.120 | absolutely convinced that they can outperform the market.

00:11:39.200 | I see the same thing that I saw back in the 1990s, the same attitudes, maybe a different

00:11:43.840 | group of people, a different generation, but it's the same thing.

00:11:47.320 | We have the rise of the day traders, if you will, supposedly using more sophisticated

00:11:53.080 | technology or whatever, but could this possibly be a signal that we're reaching a long-term

00:12:00.200 | market top?

00:12:01.200 | I don't know.

00:12:02.200 | Those are questions well worth asking.

00:12:06.160 | The nice thing, though, is that you do see what's oftentimes termed as the behavior gap,

00:12:11.960 | the difference between the time-weighted returns and the dollar-weighted returns.

00:12:15.800 | It's starting to really shrink and I think a big reason it's shrinking is that more investors

00:12:19.960 | or a higher percentage of investors are becoming buy-and-hold index investors or they're using

00:12:25.840 | more sophisticated, longer-term asset allocation plans as opposed to market timing and trying

00:12:32.080 | to jump in and out of the market.

00:12:34.440 | The more you just buy-and-hold the market, the more you're going to enhance your returns

00:12:38.120 | over time and the more you're going to get rid of that behavior gap because if you just

00:12:42.640 | buy-and-hold, your dollar-weighted return becomes essentially the same as your time-weighted

00:12:47.360 | return over time.

00:12:49.080 | I think we are seeing on the whole, through things like 401(k) plans, the great success

00:12:53.600 | of independent advisors out there helping people make better investment decisions, we're

00:12:59.360 | seeing on the whole, I think, massive improvement in the average investor's experience.

00:13:04.680 | Your comments about the investor gap shrinking, the performance gap shrinking, your own data

00:13:12.760 | at Morningstar shows that people who have been in balanced funds and target date funds

00:13:20.360 | or life strategy funds where the rebalancing is done automatically for them is actually

00:13:25.240 | a positive performance gap.

00:13:27.560 | Absolutely.

00:13:28.560 | I mean, you could actually use the bad investor behavior of others against them if you're

00:13:31.800 | a bit of a contrarian.

00:13:32.800 | So, in a balanced fund where you're reestablishing the balance, stocks go up, you sell them and

00:13:37.920 | you buy more bonds, you're constantly reestablishing that balance and you're going against the

00:13:42.560 | fear and greed emotions that investors have.

00:13:45.920 | That to me is the central investment question.

00:13:48.120 | We know that investors are driven by fear and greed, they have this manic cycle.

00:13:52.920 | I think the question all of us in and around the asset management industry have to ask

00:13:55.960 | ourselves is are we going to be a part of accelerating that fear and greed cycle, out

00:13:59.840 | promoting hot products at their peaks and then yelling run for the hills at the troughs?

00:14:05.320 | Or are we going to be a part of trying to calm down that cycle and help investors ride

00:14:09.920 | this out?

00:14:11.040 | And the nice thing is that things, as you mentioned, like balanced funds or target date

00:14:13.920 | funds, and anyone working with a good financial advisor is going to get a sophisticated, balanced

00:14:20.000 | portfolio based on good, strong asset allocation principles today, all of which are much more

00:14:25.480 | likely to lead to a better result.

00:14:27.840 | It's certainly better than calling up your broker 30 years ago and saying, "Hey, what's

00:14:31.680 | this week's hot tip?"

00:14:34.680 | Well I look at advised client portfolios every day as my business.

00:14:39.200 | Now I'm doing an hourly business and so I don't have any skin in the game anymore, I'm

00:14:43.800 | not managing money, but I do get to look at portfolios every day and many of them are

00:14:48.680 | from advisors.

00:14:49.680 | And yes, there's a subset that does it right, but there's also a subset that is all over

00:14:54.840 | the place.

00:14:55.840 | That's a very fair point.

00:14:58.200 | I wrote a commentary once called "The Third Rail," the thing that no one in and around

00:15:02.080 | financial services want to say, and that's that lots of people like to say, "Look how

00:15:05.160 | much the average investor underperforms the broad market," but the thing that they never

00:15:09.920 | throw in is that the average investor today is using an advisor, because most individuals

00:15:14.840 | use some kind of advice or they use something in like a 401(k) plan where there's someone

00:15:19.440 | who has a fiduciary responsibility.

00:15:21.440 | And so if you put those two things together, that the average investor is doing poorly

00:15:24.760 | and the average investor is working with an advisor, it means that there must be an awful

00:15:28.560 | lot of bad advice out there.

00:15:30.600 | And at one point there was more bad advice than good, I would argue.

00:15:34.080 | If you turn back the days when the wire houses sort of, their mutual funds were the biggest

00:15:38.280 | in the industry and they were some of the worst performers.

00:15:41.400 | But increasingly today assets flow to the better funds and increasingly people are deploying

00:15:46.280 | them more successfully and they're holding them for longer periods.

00:15:51.160 | They're not just trying to jump in and out.

00:15:52.840 | And so I tend to be an optimist and say, "On the whole, things are trending in the right

00:15:56.000 | direction," but I would agree with you wholeheartedly and say that we're not at that point where

00:16:00.200 | everyone's having a great experience and that there aren't still bad actors out there.

00:16:04.120 | You know, a lot of times we point to fees as the reason why active management underperforms

00:16:09.960 | indexing, and then we can look at fees for active management coming down pretty substantially

00:16:18.680 | over the past 20 years.

00:16:21.040 | The fees for indexing and index funds and passive, the traditional ones as you spoke

00:16:24.840 | about, are also coming down.

00:16:27.800 | But the irony is of the data that I look at, even though active management fees have come

00:16:32.320 | down quite a bit and traditional index fees have come down some, they were already low

00:16:38.560 | to begin with and they came down some more.

00:16:41.040 | The number of active managers that are underperforming the indexes is still the same amount.

00:16:46.760 | It hasn't come down.

00:16:49.220 | So there's something else going on there and I think the fact is active management is just

00:16:54.800 | getting tougher and tougher and tougher, as you pointed to earlier, with the quality of

00:17:00.560 | active managers that are out there.

00:17:03.080 | It's absolutely true.

00:17:04.080 | Another thing is that it's been the biggest companies that just keep getting bigger and

00:17:06.880 | bigger that are what's driving the market.

00:17:08.920 | Look what's happened with the FAANG stocks recently.

00:17:11.400 | And you think about this, an active manager might easily have three times the market weight

00:17:16.480 | in a small cap stock, but they're never going to have three times the market weight in Amazon.

00:17:21.800 | You'd have to put a double digit amount of your portfolio into that one stock and no

00:17:25.120 | one ever does that.

00:17:26.680 | And so active management tends to do better on a relative basis in small cap led markets

00:17:32.000 | than they do in large cap led.

00:17:33.880 | And certainly the kind of markets, it's an environment we've been in the last two decades

00:17:38.440 | where the biggest keep getting bigger is one that is not advantageous to active management.

00:17:45.800 | And active management, as you point out, doesn't need that disadvantage because it's already

00:17:49.040 | at a crippling disadvantage due to cost, especially if you include taxes in cost, which can just

00:17:56.920 | completely decimate the case for active management when you take into account the tax consequences

00:18:02.000 | of their actions.

00:18:04.040 | This is a really good segue into style boxes because you mentioned that the average active

00:18:09.860 | manager more equal weights their portfolio than market weights their portfolio.

00:18:14.760 | Therefore they are going to have a higher probability of having more weight towards

00:18:19.080 | mid cap and small cap individual names than say the market would.

00:18:24.360 | However, years ago you created Morningstar style boxes, which captured this and put these

00:18:30.980 | managers in the right boxes, or at least attempted to put the active managers as closest as you

00:18:37.400 | could into the right boxes to try to give you a more apples to apples comparison.

00:18:43.000 | So tell us about the whole evolution of the style boxes.

00:18:45.760 | Well, it came from attending a financial planners conference and advisors were sitting around

00:18:50.520 | the table saying, how do I explain to my client why we have more than one US equity fund in

00:18:56.120 | their portfolio?

00:18:57.120 | They said the client would say, look, we've already got this one equity fund.

00:19:00.660 | Why do we need another general equity fund?

00:19:02.200 | Let's add a gold fund or let's add a sector technology fund.

00:19:07.000 | And the advisors were saying, gee, I could see adding a gold fund or a tech fund, but

00:19:10.520 | that should be the seventh or eighth fund we add, not the second.

00:19:13.440 | How do we explain to an investor that two US equity funds might be complementary to

00:19:19.000 | each other and another two might be overlapping and that the two I'm suggesting actually complement

00:19:24.060 | each other and aren't doing the same thing and so it's actually bringing diversification.

00:19:28.060 | And what we really want to do is give the investor control over the analysis of their

00:19:32.980 | funds.

00:19:33.980 | And back then, some of our rivals in the fund tracking business, they basically just let

00:19:38.920 | fund companies pick their category.

00:19:41.180 | If they called it a growth and income fund, it went into the growth and income category.

00:19:45.060 | And yet, their definition of growth and income might be very different from someone else's.

00:19:48.300 | And we wanted to police that to a certain extent.

00:19:51.020 | And we also wanted to get rid of what I call sort of the inside baseball talk.

00:19:55.340 | Back then, you had to be an insider to know that Windsor meant large cap value stocks,

00:20:00.580 | that that was John Neff's strategy, and that Janus meant large cap growth.

00:20:05.100 | If you were an insider and you knew those things were great, but there was nothing about

00:20:07.500 | the name Windsor or Janus that gave you a clue how they were going to invest that money.

00:20:12.380 | And what we wanted to do was just create more apples to apples comparisons so an investor

00:20:16.060 | could understand, could make better comparisons between funds and could understand perhaps

00:20:21.820 | what role in a portfolio or what part of the economy or the economic opportunities a certain

00:20:27.460 | manager was mining in, and to set more realistic expectations.

00:20:31.260 | You know, to expect Windsor to outperform in a growth-led market would be foolish.

00:20:36.780 | And yet, if you didn't have that understanding that Windsor really bought value-oriented

00:20:39.820 | stocks and it had headwinds and tailwinds that were different than Janus, you would

00:20:43.340 | end up consistently selling Windsor at the time you should be adding to it and buying

00:20:47.140 | Janus at the time you should be selling it.

00:20:49.260 | So we just wanted it to be descriptive and to help people and advisors get on the same

00:20:53.980 | page and better understand and set more reasonable expectations for the funds that they were

00:20:58.780 | holding.

00:20:59.780 | >> About this time, 1994, Gene Fama and Ken French came out with their first section of

00:21:05.740 | return paper which talked about the three-factor model, beta, size, value, which was measured

00:21:13.220 | by them by book-to-market.

00:21:15.120 | How much did this influence Morningstar's decision to go with a Morningstar style box

00:21:19.440 | and how much did that work in?

00:21:21.260 | I know that your value is not book-to-market.

00:21:23.220 | You have a multi-factor approach to value and growth, but could you explain the academic

00:21:28.140 | side to it?

00:21:29.140 | >> Well, initially, the way we looked at value was just price-to-earnings and price-to-book.

00:21:33.940 | It was just those two added together, you know, the relative position and then averaged.

00:21:38.920 | I think it was a nice correlation.

00:21:39.920 | I mean, obviously, we were doing this before they were doing it, but it was already, there

00:21:44.620 | was circulation out there and you did have a handful of managers positioning themselves

00:21:48.380 | as small-cap value and some as large-cap growth.

00:21:52.460 | But most of the things that were small-cap were on the growth side.

00:21:56.100 | There used to be a small-cap category and an aggressive growth category and they tended

00:22:00.280 | to have an awful lot of gray area between them.

00:22:04.260 | So I think, you know, the academic backup of this thing that, look, size and style are

00:22:10.100 | something that has predicted value and are important differentiations.

00:22:14.980 | I think that maybe encouraged more fund companies to pay attention to this.

00:22:19.500 | And then the style box also gave, you know, this sort of the unintended consequence of

00:22:22.660 | the style box is it gave fund companies a roadmap on what kinds of products that they

00:22:26.820 | could develop.

00:22:27.820 | Because right now, you know, they could say, we could look at this nine-box grid and say,

00:22:32.040 | we've got funds that map into three of these, so now what we have to do is go out and create

00:22:35.420 | the other six.

00:22:36.420 | And, you know, that was never our intention.

00:22:38.100 | We didn't design the style box to be a marketing roadmap for product creation.

00:22:43.020 | We did it for these much more pedestrian intentions of trying to just help investors understand

00:22:48.980 | what a manager was doing and to understand that over time a manager's style might change.

00:22:52.340 | You know, someone who starts out buying small-cap stocks, as the fund gets bigger and bigger,

00:22:56.900 | might migrate more into mid-cap or large-cap territory.

00:22:59.920 | Or you could have a portfolio manager leave.

00:23:01.860 | You know, the fund's name would stay the same, but perhaps the last investor was a diehard

00:23:06.540 | growth investor and the new investor is much more value-oriented.

00:23:09.300 | You know, back in the days when fund companies just, or funds just had these poetic names,

00:23:14.860 | you saw those kinds of massive shifts in strategies that would go on with the investors not, you

00:23:19.700 | know, not at all being aware that they suddenly had a very different portfolio.

00:23:23.340 | >>COREY: Oh, like the Fidelity Magellan fund.

00:23:25.780 | >>STEVE: There was a, when we first started doing this, there were two funds called Blue

00:23:28.940 | Chip Growth, I think.

00:23:30.780 | One was from T. Rowe Price and the other was from Fidelity.

00:23:33.780 | And T. Rowe has always been a real truth in labeling shop, and so if they call something

00:23:37.220 | Blue Chip Growth, it's going to be what you and I would, and your clients would think

00:23:41.340 | of as being, you know, Blue Chip, you know, large-cap stocks.

00:23:45.140 | And I remember we looked at, like, the Fidelity Blue Chip Growth fund, and I think it's median

00:23:49.580 | market cap, where you placed it just barely in the mid-cap, just out of the small-cap.

00:23:54.260 | And I remember talking to the fund manager, and he said, "Well, I guess if pressed, I

00:23:57.420 | would have to say that I think of these as future Blue Chips."

00:24:00.460 | I said, "Well, that's great, but you're telling the world that this is a Blue Chip fund.

00:24:03.960 | They think their expectation of what they're getting is completely different from what

00:24:07.140 | your expectation is in running the fund."

00:24:10.020 | And when you have that mismatch of intention and expectation, investors tend to suffer,

00:24:15.740 | and I think the industry lets down its clients.

00:24:17.820 | >>COREY: And actually, the SEC finally stepped in on that, and was sort of a truth in labeling

00:24:22.580 | regulation that came out to ensure that if you said your fund had Blue Chip stocks in

00:24:27.820 | it, it had better at least 80% have Blue Chip stocks.

00:24:31.180 | >>GREGORY: Yeah, it's true, but it gets a little nebulous when someone's like, "Well,

00:24:34.260 | how do you define a Blue Chip?"

00:24:35.260 | There isn't some, you know, God-given stamp that said, "This is a Blue Chip, and this

00:24:38.660 | isn't."

00:24:39.660 | But you're absolutely right.

00:24:40.660 | And there was a classic example.

00:24:41.660 | Again, I think it was a Fidelity fund.

00:24:43.460 | They had an insured municipal bond fund, and John Lansner of the Orange County Register

00:24:47.940 | did a report in his local paper about what's the exposure to uninsured bonds in all of

00:24:54.060 | the different California insured municipal bond funds.

00:24:57.020 | And I think then the limit you had to have was 65% had to be in the type of security

00:25:03.460 | that your name suggested.

00:25:05.520 | And Fidelity at that time had 66% of its assets in insured bonds, and the other 34% in uninsured

00:25:11.980 | bonds.

00:25:12.980 | And the manager said, "Yeah, we think insurance is just way overpriced right now, and it's

00:25:15.460 | not worth the premium you have to pay for it."

00:25:18.660 | Well, that's great, but you're selling this to the public as something that's labeled

00:25:21.300 | as an insured municipal bond fund.

00:25:24.020 | And so it still seems to me that while the SEC has cleaned up on this and gone with an

00:25:28.380 | 80% rule across the board, there's certain words like "insured" or "government" or "treasury"

00:25:33.780 | that really pull on investors' heartstrings.

00:25:36.620 | And today, you could put four motor company bonds in a government bond fund and enhance

00:25:40.460 | your yield and not be violating any of the rules.

00:25:43.460 | Now, in practice, we don't see that much of that kind of shady dealing going on in the

00:25:48.540 | industry today.

00:25:49.540 | I think it's a cleaner, better-lit, more fiduciary-centric industry than it was perhaps 30 years ago.

00:25:53.980 | But I still think you have to be on guard against that kind of stuff, because, again,

00:25:58.220 | when you have intent and expectations varying greatly, investors oftentimes end up disappointed.

00:26:06.420 | And just look what the credit market imploded back in the financial crisis.

00:26:10.540 | You had some things that were called "government bond" that lost 30% or more, and other things

00:26:15.260 | that were called "government bond" that made money during this, and it had to do with how

00:26:19.540 | they were interpreting that mandate to invest in government bonds, and whether you were

00:26:23.100 | buying just the straight forward bonds or you were buying some kind of exotic derivatives

00:26:28.340 | somehow linked to government paper.

00:26:31.460 | >>COREY: Another benefit of indexing is the transparency.

00:26:34.220 | I mean, you do know what you're getting.

00:26:36.220 | >>STEVE: Absolutely.

00:26:37.220 | I mean, there's scores of benefits to indexing, and the longer-term view, the tax advantages,

00:26:41.860 | the truth in labeling, all of those are there.

00:26:44.900 | But that said, there's a lot of craziness under the index umbrella these days.

00:26:49.100 | Anytime something gains popularity and it's got someone like Jack Bogle at the forefront

00:26:54.060 | of it, you're going to attract shadier characters around the fringes of that who are going to

00:26:58.260 | quote Jack and say, "Oh yeah, following his great tradition, we're launching a set of

00:27:02.860 | market-timing triple-leveraged index funds, and these are good because they're index-oriented."

00:27:07.700 | They're like, "That's something Jack wouldn't touch with a 10-foot pole.

00:27:10.660 | You really shouldn't be invoking his name on something like that."

00:27:13.420 | >>COREY: Oh, I agree.

00:27:14.660 | I call it special-purpose indexing, spindexing.

00:27:20.220 | That's what it is, just spinning something.

00:27:21.740 | I mean, the fact is you create some crazy index based on the shoe size of the CEOs,

00:27:28.980 | and whether they're left-handed or right-handed, I mean, whatever it is, you create some crazy

00:27:33.100 | index, and then you turn around and you launch an ETF or a mutual fund to that index, and

00:27:40.860 | you call that mutual fund passive indexing.

00:27:43.820 | I just think that the industry is getting away with way too much when they start going

00:27:48.860 | down the road of calling spindexes or comparing spindexes to traditional indexes.

00:27:53.940 | >>GREGORY: Then you go grape yourself in the sacred cloak of indexing and invoke Jack Bogle's

00:27:59.020 | name and say, "We're doing the Lord's work."

00:28:03.820 | Jack would be rolling in his grave over there.

00:28:05.700 | >>COREY: Absolutely.

00:28:06.700 | I want to get into the rating systems that Morningstar uses.

00:28:10.980 | You have two different types of ratings.

00:28:12.220 | You have a star rating, and you have an analyst rating, so could you compare and contrast

00:28:16.980 | the two?

00:28:17.980 | >>GREGORY: Well, the star rating is something that Joe had come up with before I joined

00:28:21.620 | Morningstar, and it has some positive advantages to it, absolutely.

00:28:26.020 | One would be it's longer term oriented.

00:28:27.980 | The minimum period we look at is three years, and if we have a five or a 10 year history,

00:28:32.180 | we weight those more heavily.

00:28:34.020 | The second thing is that it's risk adjusted, so if you go out and you take a lot of crazy

00:28:37.300 | risk, you produce a very volatile stream of returns, one that investors are unlikely to

00:28:41.940 | use well, because greater volatility means there's a greater chance you buy high and

00:28:45.380 | sell low.

00:28:47.020 | You get penalized for that in the star rating system.

00:28:49.300 | The other thing is that the star ratings include all costs that a mutual fund has.

00:28:53.220 | It includes the expense ratio, but it also includes front end and back end sales charges.

00:28:57.980 | We deduct those when calculating a star rating, and this was a huge improvement at the time

00:29:03.420 | it came out, back in the mid-1980s.

00:29:07.300 | Back then, most of the comparisons you saw were things that said, "This fund is number

00:29:11.540 | one in its category," and sometimes the categories were very short term oriented.

00:29:15.580 | It could be very narrow or very short term oriented.

00:29:19.100 | It might be growth in income funds with assets of less than $25 million, and the performance

00:29:24.500 | period might be over the last three months.

00:29:26.700 | The other thing is that all of those number one in category comparisons ignored any sales

00:29:31.060 | charges that you might incur, so it was something that really camouflaged the impact of cost,

00:29:37.420 | whereas the star rating, by including the loads and by taking a longer term point of

00:29:41.820 | view where the burden of high expenses takes a greater and greater toll, or at least it's

00:29:46.460 | not camouflaged as much as it can be in short term results, the star rating was something

00:29:51.580 | that was a real important catalyst in pointing people towards not only better performing,

00:29:56.340 | or at least better historical performance and lower risk, but also substantially lower

00:30:01.380 | cost funds.

00:30:02.380 | I think that's one of the things Jack recognized right away, and an advantage in what Morningstar

00:30:07.940 | was doing, is that we were taking an approach that put more emphasis on cost than the industry

00:30:13.620 | had done to date.

00:30:16.220 | I know people will complain about the star rating and say, "Well, it doesn't tell you

00:30:18.740 | this.

00:30:19.740 | It doesn't tell you that."

00:30:20.740 | We always say, "Well, first off, we never said it told you everything you needed to

00:30:22.980 | know, but it does tell you some things that are of value," and then some people would

00:30:26.820 | come and say, "Well, I think you should just buy index funds and ignore the star ratings."

00:30:30.900 | Okay, that's fine, but traditional index funds have substantially and consistently gotten

00:30:35.780 | above average star ratings, and people say, "Well, I think you should just buy Vanguard

00:30:38.820 | and Fidelity and ignore these other three fund groups."

00:30:41.380 | Well, Vanguard has consistently had the highest, or certainly among the large fund families,

00:30:46.500 | the highest average star rating, so there's something right about them, but there's also

00:30:50.140 | something incomplete, and what we always said is that the star rating is an introduction,

00:30:53.980 | not a conclusion.

00:30:54.980 | It's a good place to begin to screen down the universe to a more manageable size, because

00:30:59.980 | there are tens of thousands of funds out there.

00:31:02.460 | You just can't possibly look at all of them.

00:31:04.780 | You need to have some kind of mechanical way of reducing it to a more manageable task.

00:31:09.380 | Then you started analyst ratings, where you gave them gold, silver, bronze.

00:31:17.140 | This was more forward-looking, correct?

00:31:19.180 | Yeah, and that was the intent.

00:31:21.220 | We recognized the shortcomings of the star ratings.

00:31:22.980 | In fact, we conceded them before most people recognized it.

00:31:25.820 | We never ran an ad that said, "Follow the stars to riches.

00:31:27.940 | This is all you need."

00:31:28.940 | Yeah, but there were a lot of ads that said that, but you didn't say it.

00:31:33.740 | Yeah, yeah, and again, you have to go back and say, "Well, what would it be better?

00:31:37.700 | Would it be better that they're quoting the star rating that's long-term, risk and cost

00:31:40.620 | adjusted, or short-term number one in its category, when you don't even know what other

00:31:45.180 | funds are in the category, and you know that it's ignored the sales charge?"

00:31:49.780 | It was an improvement at the time, but it wasn't everything, and that's why we did the

00:31:53.900 | analyst rating.

00:31:54.980 | We knew that we produced a whole page of research, and the star rating was just one of hundreds

00:32:00.420 | of data points on there.

00:32:01.780 | Oftentimes, our analysts would say, "This fund currently has a five-star rating, but

00:32:06.180 | here's the reasons why we would be cautious and wouldn't think that that's predictive

00:32:09.380 | of the future.

00:32:10.380 | Perhaps there's been a manager change, or perhaps it's just a three-year record, not

00:32:14.220 | a five- or a ten-year record, or perhaps the fund has had a certain tailwind that our analysts

00:32:18.300 | thought was unlikely to continue."

00:32:20.620 | We wanted to get more of that information into the starting point analysis, because

00:32:25.300 | we knew that some people just stopped at the star rating.

00:32:28.900 | That's where the analyst ratings came about.

00:32:30.860 | As we built up a global team of analysts that was capable of doing this kind of due diligence

00:32:37.740 | on funds, we decided to put more of that into a rating so that people could have something

00:32:44.620 | that would be more stable than the star ratings, and it would include more of our best thinking.

00:32:49.820 | Again, we did not adjust a star rating if a portfolio manager left, because you never

00:32:55.380 | really knew on the outside how important was that manager, and how important was the team,

00:32:59.580 | and all kinds of variables that you didn't know that were very hard to get into a mechanical

00:33:04.580 | thing like the quantitative star ratings, but we could get into the more subjective

00:33:09.740 | analyst ratings.

00:33:11.780 | That was the intent, was to give investors a better starting point than the star ratings.

00:33:16.100 | I'm going to ask the tough question here, because you do have advertisements for mutual

00:33:22.900 | funds in your magazines, and in your publications, and such, and they have a tendency to want

00:33:31.820 | you to say certain things about them, and to give them certain ratings, and so forth.

00:33:39.620 | There's a pay-to-play element in the financial media that basically you pay us money and

00:33:49.660 | we'll say good things about your fund and your fund company.

00:33:53.220 | Can you comment, number one, about the whole industry, and number two, about Morningstar's

00:33:57.260 | approach to this?

00:33:59.940 | We didn't have advertising in our products for a long time, and as we moved into the

00:34:04.060 | web, we started taking ads.

00:34:07.660 | The old research publications didn't, but on the web, it's part of the business model.

00:34:12.380 | What we did is we said, "Well, look to the people we admire most," and we looked to The

00:34:15.460 | Wall Street Journal, we looked to The Economist, we said, "Look, there are plenty of examples

00:34:19.180 | where you've got an editorial function that is kept separate from the advertising, and

00:34:25.420 | it's just not that difficult to do if you've got the right culture, and you set up the

00:34:28.940 | right parameters."

00:34:30.700 | We hold our analysts to one standard and one standard only, but the only thing we hold

00:34:34.340 | our analysts to is, "Are you telling the story as fairly and accurately as possible from

00:34:38.900 | the investor's point of view?"

00:34:41.020 | That's the only standard that our analysts are held to.

00:34:44.660 | Our analysts sign their work, it's out there for the world to see, and it's out there with

00:34:47.900 | all of the supporting data.

00:34:50.180 | Anyone reading this can look and see, "Okay, the analyst says this fund has a consistent

00:34:54.140 | history.

00:34:55.140 | Well, let's go look at the returns.

00:34:56.140 | How consistent have they been?"

00:34:57.580 | I think it's as transparent as it can possibly be in a realistic business model for the web.

00:35:04.820 | >> Let's talk about exchange-traded funds.

00:35:06.980 | You were around when they launched the first one back in 1994, and I personally started

00:35:12.980 | using them in 1996, so there was only two of them.

00:35:16.500 | There was SPDRs and MIDIs, but I could see that this was the future.

00:35:24.300 | You picked up on that right away also, that this was the future.

00:35:27.780 | >> Sure.

00:35:28.780 | Well, you were really prescient, Rick, and you were among the early advisors to really

00:35:33.100 | latch onto this, and a lot of advisors wouldn't because there wasn't some kind of a commission

00:35:37.820 | baked into it.

00:35:39.260 | I think what set you apart is that you're looking at this from the point of view of

00:35:43.900 | the investor.

00:35:44.900 | If you were looking at it from the point of view of someone who's trying to make a buck

00:35:47.540 | selling stuff, then maybe they weren't nearly as attractive, and that's why they got ignored

00:35:51.340 | for a while.

00:35:52.620 | We came at it from the same point of view as you did and say, "Look, this is low-cost.

00:35:56.420 | This is good.

00:35:58.860 | We don't see the issue."

00:35:59.860 | I remember Jack Bogle had a big issue with it.

00:36:01.780 | He had his shotgun analogy, saying this is a very powerful tool that could be used for

00:36:06.500 | self-defense or for murder and things like that.

00:36:10.740 | Then when Vanguard came up with some very creative ways of attaching them or linking

00:36:14.820 | them to their existing funds and the tax advantages that they have, they really do have material

00:36:20.180 | advantages and the low-cost and the transferability of them to move them from one account to another.

00:36:26.740 | There's some powerful advantages for the investor.

00:36:30.700 | We were championing them because our moral compass always pointed to do what's right

00:36:34.860 | for the investor.

00:36:35.860 | If the investor wins, everyone else in the process can succeed, but if the investor is

00:36:39.580 | suffering and not doing well, then all of us have failed to do our job.

00:36:44.100 | I recall when I first started looking into ETFs, it was around 1996 when I had my epiphany,

00:36:53.700 | my aha moment, listening to Jack Bogle and reading his books and coming up with why aren't

00:36:58.940 | I doing this for my client.

00:37:00.940 | I started looking around.

00:37:01.940 | I was working at Smith Barney at the time.

00:37:04.100 | I was looking around saying, "Okay, where are the index funds?

00:37:07.740 | Where can I find index funds?"

00:37:08.900 | Of course, you couldn't find any index funds that weren't available, but by 1998, actually,

00:37:15.380 | Smith Barney did launch a clandestine index fund.

00:37:18.420 | You could find it if you wanted.

00:37:19.740 | We actually had one.

00:37:21.060 | It was buried deep, deep, deep down in the Smith Barney mutual fund platform that was

00:37:25.700 | never advertised and nobody knew about it, but it was there and you could use it.

00:37:29.820 | It was relatively low cost because they didn't want people running to Vanguard, but the only

00:37:34.500 | thing that I really had available was ETFs.

00:37:39.940 | That's where I started putting client money.

00:37:44.820 | I remember going to Jamie Dimon and I said to him, he was the president, and I said,

00:37:48.860 | "Jamie, we should do this," and he had no interest in it whatsoever.

00:37:53.460 | Now everybody's doing it.

00:37:55.020 | >> It didn't fit the old brokerage model.

00:37:57.900 | >> No, it certainly didn't fit the model because there was no money in it.

00:38:00.940 | There was no 12B1 fee.

00:38:06.660 | These companies, Vanguard wasn't about ready to pay any brokerage firm a half a million

00:38:12.500 | dollars a year just to get in the door and buy pizza for the advisors and tell them about

00:38:20.260 | these things.

00:38:21.260 | >> Pizza's the least of what the advisors were asking for.

00:38:25.780 | >> Let's talk about advisors because we're into this.

00:38:28.420 | You talked about the evolution of active funds and how it's getting tougher for active managers

00:38:36.060 | as the world is getting smarter.

00:38:39.060 | What about advisors?

00:38:40.060 | You've written a lot about this.

00:38:41.460 | In fact, a lot of the audience for Vanguard is advisors.

00:38:44.980 | You have a big advisor conference every year.

00:38:47.260 | How do you see that industry evolving and changing?

00:38:51.020 | >> It's been a massive change in my lifetime.

00:38:54.020 | The first advisor I met was my father's stockbroker.

00:38:57.020 | My dad would go to her for ideas on what stock should I buy.

00:39:01.860 | The advisors started as people that would pick individual securities.

00:39:04.940 | Then in time, they said, "You're not really very good at that.

00:39:08.100 | You shouldn't be doing that.

00:39:09.100 | You can't pick stocks, but you can pick managers, so go out and pick active managers."

00:39:13.900 | That became the bread and butter trade of many advisors for a number of years.

00:39:19.100 | Then, as we've talked about, it got harder and harder to pick successful active managers.

00:39:24.060 | Many asset management shops turned into soap operas.

00:39:26.200 | The star managers become divas, and they leave in a huff.

00:39:29.380 | All of a sudden, you've got all these tax consequences, and you've got to run and reshuffle.

00:39:33.020 | The case for passive investing just became stronger and stronger.

00:39:36.380 | The mantra among advisors came, "We can't pick stocks.

00:39:38.620 | We can't pick active managers, but we can pick asset classes.

00:39:41.980 | We can pick a whole bunch of indexes, and we can put together a good portfolio."

00:39:46.020 | That was the model for some time, but now I think you're even seeing that begin to change

00:39:50.100 | and morph.

00:39:51.100 | Tim Buckley, the new head of Vanguard, in his first couple of weeks taking over as CEO,

00:39:56.380 | he started making some statements saying, "We really don't think advisors should be

00:39:59.220 | putting together portfolios.

00:40:00.920 | We don't think they should be in that business.

00:40:02.260 | We think they should be buying model portfolios, and that our people can put together these

00:40:06.540 | portfolios and manage them and rebalance them better than many advisors can."

00:40:10.860 | If you think about it from that perspective, the advisor has been pretty much pushed out

00:40:15.340 | of the entire investment part of the investment management process.

00:40:19.900 | The fascinating thing is, even with all of these things happening, the advisor's role

00:40:25.980 | and the commitment that clients have to their advisors is as strong as ever, which suggests

00:40:30.820 | that in many cases, what the clients really wanted from the advisor was something other

00:40:34.860 | than some kind of mythical investment genius.

00:40:37.900 | What they really wanted was some hand-holding and someone to listen to them and someone

00:40:41.260 | to match their goals to an investment portfolio.

00:40:45.520 | Advisors are doing that today and providing an incredible value for their clients, even

00:40:49.940 | if they're not picking the next hot stock or the next star manager.

00:40:55.260 | I think the role of the advisor has really shifted phenomenally in the last 30 or 40

00:41:01.380 | years, but the importance that the advisor has for the client hasn't diminished at all.

00:41:07.420 | Most investors want to be working with someone if they navigate these difficult financial

00:41:11.700 | planning decisions.

00:41:13.660 | Although I see the way that advisors get paid is now becoming more in the spotlight.

00:41:20.780 | I've been on all sides of it, Don.

00:41:22.740 | I started out in the brokerage industry doing commissions and then went to the AUM, Assets

00:41:29.380 | Under Management business.

00:41:30.580 | I had my own advisory firm doing AUM for almost 20 years, and now I'm doing an hourly model.

00:41:37.540 | What I see, again, from looking at all these portfolios that I see every day, is I see

00:41:42.340 | advisors who want to get assets under management.

00:41:46.260 | They do things that sometimes I don't agree with.

00:41:49.700 | Just yesterday, I was talking with a client, and his advisor had him roll money out of

00:41:58.780 | a 401(k) into an IRA that the advisor could manage, and then when the client got another

00:42:05.340 | job at a company that had a very, very good, low-cost 401(k), he didn't advise the client

00:42:10.460 | to move that money into the new 401(k) because he would have lost the assets under management.

00:42:15.380 | That precluded the client from doing a backdoor Roth and a mega-backdoor Roth, and it was

00:42:20.620 | paying management fees to this advisor.

00:42:23.580 | In other words, the incentives of AUM to the advisor caused the advisors not always to

00:42:30.660 | make the most fiduciary decisions for the clients.

00:42:34.340 | Yeah, I think you're right.

00:42:36.700 | There are issues.

00:42:37.700 | On the other hand, I think most clients prefer it, not having to write out a check, have

00:42:42.100 | it collected seamlessly, and from the advisor's standpoint, it's delightful.

00:42:46.420 | If you can get paid in basis points, what a wonderful way to earn money.

00:42:51.300 | I remember one of the first fund managers I ever saw speak was a guy named Tom Ebright

00:42:55.300 | who ran money for Chuck Royce, and I remember him saying, "I get up in the middle of the

00:42:59.060 | night, and I go to the bathroom, and I'm making money.

00:43:01.300 | I'm getting paid.

00:43:02.300 | I'm getting paid around the clock all the time as long as that meter is ticking on the

00:43:06.260 | AUM fees."

00:43:07.260 | If you're getting paid on assets under management, you have very little incentive to leave it,

00:43:12.500 | and as a client, even if you might look at it and say it doesn't really ... There may

00:43:16.860 | be some issues that are bad.

00:43:18.620 | Most people prefer to pay in this seamless way.

00:43:21.260 | That said, I think there are two things that the industry really needs to think about is

00:43:24.260 | that the AUM model does not work at all for the small client, nor does it work well for

00:43:29.740 | the large client.

00:43:30.740 | For the small client, if they don't have any assets, then there's no incentive for financial

00:43:35.900 | advisors to reach out and help these people.

00:43:39.260 | That's a major issue that's going to have more and more attention over the next couple

00:43:42.660 | of years.

00:43:43.660 | How do we reach out to underserved communities?

00:43:45.580 | How do we make more people in America investors, or how do we help small investors become more

00:43:50.180 | meaningful investors, and how does the financial planning community reach out to these underserved

00:43:54.540 | communities?

00:43:55.540 | Then, on the other hand, advisors have their very successful clients who may now have tens

00:44:01.100 | of millions of dollars.

00:44:02.100 | Maybe they've sold a business or something like this.

00:44:04.860 | Well, for them, paying a percentage of assets under management is a huge, huge check that

00:44:09.820 | they're writing, or they're not even writing it, but they're paying each year, and as they

00:44:12.960 | wise up, I think a lot of these people would come back and say, "Hey, let's negotiate a

00:44:16.100 | flat fee.

00:44:17.100 | That makes more sense to me."

00:44:18.100 | AUM doesn't work from the advisor's perspective with small clients, and it doesn't work from

00:44:21.900 | the client's perspective with large clients, but for the vast majority of people that the

00:44:26.660 | planning community works with, even though there are issues that you correctly point

00:44:30.500 | out that can create, perhaps, false incentives, I think it's one that's sort of a preferred

00:44:35.900 | methodology or preferred method because of its seamless nature for most participants

00:44:42.020 | and most advisors.

00:44:43.020 | Well, we could have a long discussion about that, but ...

00:44:47.060 | Well, I'm arguing we're going to an hourly thing.

00:44:50.220 | Oh, it's not easy.

00:44:51.220 | I prefer that, though.

00:44:52.220 | It's certainly not easy because you're only getting paid for the work that you do.

00:44:55.340 | It's not like that other advisor saying, "Hey, this is wonderful.

00:44:58.460 | As I'm sleeping, I'm making money."

00:44:59.800 | I mean, is that what a fiduciary would say?

00:45:01.900 | Well, exactly, and you don't pay your accountant that way.

00:45:04.860 | You don't pay your tax advisor.

00:45:05.980 | You don't pay your estate planning attorney that way.

00:45:08.100 | I mean, I do think that the trend is going to be in that direction, but given that AUM

00:45:13.340 | is so set up and so established, and clients aren't rebelling against it, and for most

00:45:19.700 | clients it probably wouldn't mean a major savings that they did that.

00:45:22.980 | It might just clear up some of those potential conflicts.

00:45:24.980 | I just don't know if there's a catalyst for moving away from it, but I certainly agree

00:45:30.060 | with you philosophically that if you paid on an hourly basis, it would probably be better

00:45:35.260 | for the client.

00:45:37.660 | Let's talk about something that is a move away from at least high-cost AUM, like 1%

00:45:44.780 | or so AUM fees, and that is the robo-advisor trend.

00:45:48.700 | Vanguard just launched a new robo-advisor, a true robo-advisor.

00:45:53.560 | They have the PAS program, which is 0.3% when you're talking to an advisor.

00:45:58.700 | You get the same four-fund portfolio, but you get to talk to an advisor, and now they're

00:46:02.400 | at a 0.15% internet-only advisor program where you're not talking with anybody, but the cost

00:46:08.740 | of just getting a portfolio managed using a robo-type platform continues to come down.

00:46:15.700 | I think this is a good thing.

00:46:16.700 | I mean, there are many more people that need financial planning that are getting it or

00:46:20.500 | need investment advice that are getting it, and there are big audiences that the planning

00:46:24.780 | community just has to kind of turn their back on because it doesn't make economic sense

00:46:28.140 | to serve them.

00:46:29.140 | So the small investor with a 401(k) plan, if they can tap into some robo-advice and

00:46:33.660 | have a more diversified portfolio and build up a bigger nest egg until they get to the

00:46:37.620 | point where a financial advisor would take interest in them, and also before they get

00:46:41.820 | to the point where they've got the more sophisticated questions that an advisor can really add value

00:46:45.500 | on -- things about tax decision or charitable giving or estate planning and all of these

00:46:50.940 | -- the world of different things that advisors bring to the table.

00:46:54.980 | I think this is a good thing.

00:46:56.260 | So I don't see it as a threat, I just see that there's more work to be done, more people

00:47:00.420 | that need some kind of help, and that these are going to be a big part of the future.

00:47:05.740 | And I do think that the biggest robo-advisors are not going to be some kind of high-tech

00:47:10.780 | startup.

00:47:11.780 | It's going to be Vanguard, and it's going to be Schwab, and it's going to be people

00:47:14.220 | that already have assets under management and can layer on these additional services

00:47:18.460 | at a low cost to the asset management service they're already providing.

00:47:22.560 | They're going to be the big players here.

00:47:24.940 | One new type of indexing that's available -- it's actually been around for a long time,

00:47:30.460 | but it has become more popular lately -- is direct indexing, which is building your own

00:47:37.940 | portfolio of 500 stocks, and then selling off individual stocks that are at a loss so

00:47:46.140 | you can generate tax losses, which you can use against capital gain that you might have

00:47:52.300 | from selling a business or something, or a single-stock position from RSUs or whatever

00:47:56.740 | you have.

00:47:58.060 | And this is a growing business.

00:48:01.980 | What are your feelings about it?

00:48:02.980 | I have mixed feelings about it.

00:48:05.420 | Well, I think parts of it are really cool.

00:48:07.980 | I like the idea.

00:48:09.420 | I also suspect it's more sophistication than your typical investor needs or wants.

00:48:15.140 | But the great thing to me is you're seeing a spectrum of opportunities, and you can decide

00:48:18.420 | to invest at whatever level of complexity that you like today.

00:48:21.860 | You can do one-stop shopping, just buy a TargetAid fund or a balance fund and just leave it there,

00:48:26.940 | or you could assemble a portfolio of individual funds, or you can just buy an index fund,

00:48:30.860 | or you can create your own index.

00:48:32.140 | I mean, there are just so many good solutions out there, and you and your advisor just have

00:48:37.700 | a decision, what complexity level do we want to play the game at?

00:48:41.380 | And I think that's a wonderful thing.

00:48:42.860 | So I think direct indexing can be a very good thing, but I think most people come to mutual

00:48:47.420 | funds because they want it to be simpler, and they're not looking to add complexity.

00:48:51.500 | But there are some cases where, as you point out, perhaps you've sold a business or you're

00:48:56.060 | selling a business and you've got a lot of capital gains and you want to find ways to

00:48:59.020 | offset them, but look at how tax-efficient a broad-based total market ETF is today.

00:49:07.020 | What kind of additional benefits are you going to get from direct indexing, and do the costs

00:49:11.740 | perhaps outweigh that?

00:49:14.220 | Those are open questions.

00:49:15.220 | But the nice thing is that we're competing on what's a better offer for investors as

00:49:18.100 | opposed to what's a better deal for those people trying to sell you an investment option.

00:49:23.180 | So I see that as being on the positive side of the ledger.

00:49:27.260 | Let's talk about ESG, environmental, social, and governance, and the kind of the start

00:49:36.700 | and stop that we have seen in this over the years.

00:49:39.700 | We've had social responsible that sort of started and then it stopped.

00:49:43.620 | Now we have ESG, which seems to be getting traction in this social environment that we're

00:49:48.940 | in.

00:49:49.940 | Do you think this is it?

00:49:50.940 | Do you think it's going to grow now?

00:49:51.940 | I do.

00:49:52.940 | I'm in favor of this.

00:49:53.940 | I think it's a good thing.

00:49:54.940 | And to me, it gets back to investor rights.

00:49:58.500 | And I think in the early days of Morningstar, what we were fighting for is that investors

00:50:02.040 | had a right to know how their money was being managed, what the costs were, who the portfolio

00:50:05.940 | manager was, what the fund was actually doing.

00:50:09.300 | And I think today you can extend that and say, look, as an investor today, you might

00:50:13.260 | have concerns that go beyond just your mercenary ones and beyond just finances.

00:50:17.680 | You want to know what impact your money is having on the world around you.

00:50:21.300 | And you shudder at the fact that maybe you're making a profit from a company that's out

00:50:25.240 | polluting the environment that your children and your grandkids are going to live in in

00:50:28.440 | the future.

00:50:29.540 | And so I think investors have every right to know what impact their money has.

00:50:32.820 | So more transparency, more data on environmental governance, social issues, I think these are

00:50:39.820 | positive trends.

00:50:40.820 | And I do think we're going to move from more of a shareholder oriented focus to a stakeholder

00:50:46.500 | oriented focus, simply because the shareholders have needs beyond their financial ones.

00:50:51.460 | They have concerns about the environment, about society.

00:50:54.300 | And we're seeing that with young people very much today.

00:50:57.860 | My son, he buys stocks, he buys funds, but he does a lot of due diligence, or he does

00:51:03.460 | as much due diligence, I would say, on the ESG factors as he does on the financial ones.

00:51:08.860 | And I think that's a trend that's going to stay.

00:51:12.180 | And I think it's all about investor rights, that you have a right to know what impact

00:51:15.700 | your investments have on the world around you.

00:51:19.540 | Money is a means to an end, it's not just a goal in and of itself.

00:51:22.940 | It's not some game where whoever ends up with the biggest pile of greenbacks wins and everyone

00:51:27.660 | else loses.

00:51:28.660 | It's about reaching your goals and defining your own success.

00:51:34.180 | And if being a participant in a process that makes the world more the kind of world you

00:51:39.500 | want to live in, that's a very viable concern for your money.

00:51:46.700 | Let's talk about a couple more topics.

00:51:49.620 | One of them is fixed income.

00:51:52.300 | So we've reached an interesting place in history here, where interest rates are going to remain

00:52:00.020 | very low for a very long period of time.

00:52:03.020 | In fact, the Federal Reserve is changing the way they operate relative to inflation, where

00:52:12.580 | basically going to let inflation rise, as opposed to trying to cut off inflation to

00:52:19.540 | make sure that it doesn't get above their 2% target.

00:52:22.140 | Now, these are all big changes to a financial system that are going to cause and are causing

00:52:30.620 | valuations of all asset classes to change.

00:52:34.300 | I want to hear your feelings about what you think this all means.

00:52:38.540 | Those are great questions, because it potentially means that any kind of backward-looking asset

00:52:45.060 | allocation and research that we do may be of very little utility, because we're entering

00:52:51.780 | into a future that's going to look very different from the past.

00:52:55.060 | And the same thing happened when we went off the gold standard.

00:52:57.820 | And you need to think about what are the implications of that, because suddenly fixed income returns

00:53:02.740 | may look very different than they have in the past.

00:53:05.860 | Certainly, the benefit of being in fixed income today is much harder to make a pound-the-table

00:53:10.460 | argument for.

00:53:11.460 | If you can get a higher yield from buying the S&P 500 than you can from buying a lot

00:53:15.700 | of bond funds, especially if you're looking at a high-cost bond fund and a low-cost S&P

00:53:20.580 | index fund, it's kind of hard to make the case that we need to be in fixed income in

00:53:24.700 | a major way.

00:53:26.180 | And I understand that responsible advisors and Vanguard and others still make the case

00:53:29.980 | that you need fixed income.

00:53:30.980 | And I don't disagree with that, because it certainly adds balance and maybe gunpowder

00:53:37.980 | or something or firepower for the future to the portfolio.

00:53:41.840 | But the benefits of fixed income, it's hard to see how you can use that as a major asset

00:53:46.700 | towards wealth creation going forward.

00:53:50.820 | And it has been an enormous engine of wealth creation for the last 30 years.

00:53:55.820 | I don't see how you can argue it's going to be that way for the next decade.

00:53:58.500 | I know.

00:53:59.500 | It's going to be tough.

00:54:00.500 | And a lot of people who are retired and relying on fixed income, or if they're going to

00:54:03.740 | annuitize their lump sum, the payouts are going to be smaller.

00:54:09.020 | It's pushing people into more risky asset classes, and that could have consequences

00:54:14.100 | also.

00:54:15.100 | It certainly could cause the market to go to P/E levels that we hadn't seen in many,

00:54:20.220 | many years.

00:54:21.220 | Exactly right.

00:54:22.220 | And the net result is that the investor will be exposed to greater risks because of it.

00:54:26.700 | And some of the things that people had counted on for their retirement years, the ability

00:54:31.060 | to, say, lock in a rate of return near the 4% to 5% rate, which would get you those long-term

00:54:39.140 | stability of assets that you need in many of the retirement models, you're not going

00:54:43.980 | to get that from fixed income.

00:54:45.020 | You're only going to get it from taking higher risk.

00:54:47.180 | And that's a dangerous position to be in when you've got the baby boom generation on the

00:54:50.780 | cusp of retirement.

00:54:51.780 | Yeah, absolutely.

00:54:53.460 | One final item, and that is cyber currencies.

00:54:57.460 | How long do you think it will be before cyber currencies make their way into Schwab, Fidelity,

00:55:07.100 | Merrill, where they become part of the asset mix for advisors and investors?

00:55:15.420 | You know, Rick, I'm not an expert on this, so please take whatever I say with a huge

00:55:20.980 | grain of salt.

00:55:22.340 | I would say that, you know, currencies aren't something that investors have used successfully

00:55:27.260 | in their investment programs historically.

00:55:29.500 | So I don't think that aspect is going to become a huge one.

00:55:32.740 | What I would say is that you'll probably see, you know, there'll be maybe early adopters.

00:55:35.920 | I think there are some benefits to these.

00:55:39.220 | My guess is that you'll see Vanguard be among the later ones.

00:55:42.100 | They'll let others go out and test the waters.

00:55:45.460 | Most asset firms that I talk to, they're interested in the technology behind cybersecurity for

00:55:50.940 | internal processing, for a lot of different things.

00:55:53.700 | But cyber securities as an asset class, I think, have a long...are probably something

00:56:00.780 | on the horizon.

00:56:01.780 | But we have a long way to go before you can say that investing in those is a well-researched,

00:56:06.640 | responsible choice, you know, something that sort of would fit the prudent man rule.

00:56:11.320 | And my guess is that a firm like, say, Vanguard or T. Rowe that, you know, tend to be more

00:56:16.100 | conservative will let some other firms, you know, go out there and test the waters first.

00:56:22.060 | And change always happens at the margins.

00:56:23.620 | It's not the established players that are the first to embrace a new technology.

00:56:27.180 | It's some that come along and embrace it, and some get burned, and others figure out

00:56:29.820 | ways to make it work.

00:56:30.820 | And I think if you're an investor who's interested in it, you know, wait and see who figures

00:56:34.100 | out how to make this work and really benefit a portfolio.

00:56:37.980 | You don't have to be the first to try something.

00:56:39.580 | It can still have benefits for you down the road once some of the kinks have been worked

00:56:44.740 | out.

00:56:45.740 | I see a world, maybe when my grandchildren are my age, I see a world where they might

00:56:52.380 | be trading S&P 500 coins globally, along with MSCI coins and total bond market coins.

00:57:04.140 | In other words, a portfolio instead of a portfolio of mutual funds or portfolio of ETFs, they

00:57:09.460 | actually have a portfolio of coins or cyber currencies that have the backing of markets

00:57:15.500 | all over the world, where these things trade all over the world in any market.

00:57:19.540 | It's like their Pokemon games that they've been playing for years, right?

00:57:23.340 | Exactly.

00:57:24.340 | Only this is a 24-hour-a-day, seven-day-a-week market, and it's all done through cyber currency.

00:57:31.300 | So that's what I envision.

00:57:32.620 | It could happen.

00:57:33.620 | And the thing, you know, when you and I got into this business, would you ever have imagined

00:57:37.340 | ETFs and the range of choices that you have in them, and what a great toolkit the investor

00:57:42.900 | today has, compared to what we had 30 years ago?

00:57:46.700 | Today, the toolkit that the investor has is phenomenal.

00:57:49.520 | The number of quality, low-cost, high-quality options that are out there for investing is

00:57:54.380 | staggering.

00:57:55.380 | I mean, today, the individual investor has the tools that only the most sophisticated

00:57:59.500 | pros had 30 years ago.

00:58:02.340 | So I think it boggles our mind what might be out there 30 years from now, but I can

00:58:07.500 | tell you the one thing I do know is that the things that win are going to be those that

00:58:11.100 | serve investors well, and the failures are going to be those things that over-promise

00:58:15.420 | and under-deliver and disappoint investors.

00:58:17.300 | Don, it's been a real pleasure having you on "Bogleheads on Investing."

00:58:21.180 | Thank you so much for your time.

00:58:22.380 | Rick, thank you very much.

00:58:23.380 | And my heart goes out to the Bogleheads.

00:58:24.700 | I think you guys are just phenomenal, and I know how much the Bogleheads meant to Jack

00:58:29.060 | Bogle, and Jack is one of my great heroes.

00:58:32.660 | I saw how touched he was by the love and the affection that the Bogleheads poured out,

00:58:37.140 | but more than that, I think he'd be incredibly proud by the work that they continue to do,

00:58:40.900 | and being out there and being advocates for better investor outcomes, and that's something

00:58:46.220 | that I know he would share.

00:58:48.460 | Thank you.

00:58:49.700 | This concludes "Bogleheads on Investing," episode number 25.

00:58:53.140 | I'm your host, Rick Ferry.

00:58:55.340 | Join us each month to hear a new special guest.

00:58:58.780 | In the meantime, visit Bogleheads.org and the Bogleheads Wiki.

00:59:03.820 | Participate in the forum and help others find the forum.

00:59:08.060 | Thanks for listening.

00:59:15.940 | (upbeat music)

Bogleheads® on Investing Podcast 025 – Don Phillips, host Rick Ferri (audio only)

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