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

Hi everyone, my name is Rick Ferry and I'm the host of Bogle Heads on Investing. This podcast, as with all podcasts, is brought to you by the John C. Bogle Center for Financial Literacy, a 501(c)(3) nonprofit organization that can be found at boglecenter.net. Today our special guest is Don Phillips.

Don is a former CEO of Morningstar and a managing director who remains involved with corporate strategy and investment research. Don joined Morningstar in 1986 as the company's first mutual fund analyst and soon became the editor of its flagship publication, Morningstar Mutual Funds. He established an editorial voice for the company, and under his leadership, the company developed Morningstar style boxes, a Morningstar rating system, and many analysis techniques that are stable in the mutual fund industry today.

This podcast is a fast-moving discussion about many topics of interest in the mutual fund, ETF, and advisor industries, and we even touch on federal reserve policy and cybersecurity. So fasten your seatbelts, here we go. I'm delighted to have with us today Don Phillips. Welcome to the podcast, Don. Thank you, Rick.

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

My dad bought me 100 shares of the Templeton Growth Fund for Christmas one year, and then he sat me down on Friday night when Wall Street Week with Louis Rukeyser was on, and John Templeton was the guest host. And I was just so impressed. It's like, here I am, this little paper boy, and here's my personal money manager on national television.

And it just really was amazing to me. It just sort of opened up a world for me, and for a long time, I thought of Templeton as a role model. And I think it was only later in life that I realized that the real role model was my father.

And it was for me that investing was something that he did as a responsible adult, and it was something that I could do. So I had an early introduction to funds, and really thought it was a sensible way to invest. I studied economics at college and completed all my coursework in economics, but then switched over to English literature and was pursuing a master's degree in literature at the University of Chicago when I decided to sort of flip things around.

I was thinking that I'd become a college professor, but be an active investor on the side. And I decided to flip that around and say, "Well, why don't I get a job writing about researching investments, hopefully mutual funds, and then read the great books on the side?" And Joe Mancedo ran an ad in the Chicago Tribune that said, "Wanted Mutual Fund Writer." And I sent him an impassioned letter saying, "This is exactly what I want to do with my career." We came in and talked for an hour about John Templeton, and two days later, he called up and offered me the job.

>>Corey: Now, if I recall a story about Joe doing mutual fund analysis at his kitchen table, is that- >>Steven: I joined Morningstar after Joe had moved out of the apartment, so I never had to deal with the dirty socks on the floor, things like that. He was in the Monadnack building in Chicago, had just sort of moved in there.

But he'd started the company in '84, so he'd been around for about 18 months to two years before I joined. And he was already putting out the Mutual Fund Sourcebook, which had a tremendous amount of mutual fund data in it. It had holdings. It only covered equity funds. He wasn't quite sure how it was going to cover bond funds at the time, and it didn't have any analysis of the individual funds, but it did have the star rating.

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

>>Corey: I recall the first job I had in the industry, I was working at Kidder Peabody, and we used to begin to get these paper editions of Morningstar printed on newspaper-type print, and they were fascinating to go through them. There was such great information. Eventually, this continued to grow, and at one point along the way, you got to meet Jack Bogle.

Can you talk about your relationship with Jack? >>Steven: Well, Jack became an early and ardent supporter of Morningstar, and he was talking about it in the press before I ever met him. I remember one early quote he said, something along the lines of, "I bow to no man in my respect for Morningstar," and I think what he realized early on is that we were coming at investing from the same point of view that he did, and that we believed if the investor doesn't win in the long run, everyone else in the process has failed.

It all has to be about investor success and helping people meet their goals. It's not just about making a lot of profits for the asset management company or for the person selling the funds. It's about the investor. I think Jack also realized that we were shining a light on the playing field, and that the more it became a clear, well-lit, even playing field, the more the cost advantages that he had at Vanguard and the superior investment product would win out over time.

He was a big early supporter of ours, and I've always appreciated that, but it's simply because we had philosophically the same mindset about doing what's right for investors. >>So you had to review all these active funds. That was your first job, and write about them, and really get into the nitty-gritty detail.

You were truly a mutual fund analyst, and probably one of the first ones out there, but you eventually started to have an affinity for index funds. Can you talk about how that "aha" moment occurred? >>Well, I don't know that it was an "aha" moment. We were always just looking for things that are good for investors.

Index funds clearly were good for investors. It's broad-based diversification, low cost. I should back up and say maybe what Jack Bogle would call a traditional index fund is good for investors. Later on, we saw some bad behavior under the index tent. >>Absolutely. >>At one point, there were scores of index funds that had turnover ratios of more than 100% a year, or expense ratios of more than 1% a year.

As Jack Bogle would say, the whole case for indexing falls apart if it's not prefaced by the words "low cost" and "low turnover." They were broad market indexing. Indexing just became more and more compelling, interestingly, as active management became better. That's sort of the paradoxical part about it. For one segment of the market players to better the averages, you've got to have some other group of participants who are underperforming.

For years, those underperforming participants that allowed active managers to be above average were the individual investors, or the shoot-from-the-hip stockbrokers who were advising individual investors. These individual investors going out trying to play the market oftentimes had very poor results. You may recall back then, they used to talk about this thing they called the "odd lot theory." >>Oh, yeah.

>>That meant when the volume of small trades, odd lots being buying securities in less than 100 share blocks, when the volume of that went up, it meant that individual investors were piling in the market, and that was a sign of a market top. For a long time, you did get superior performance among active managers because you had this underperforming group of individuals.

What happened over time is those individuals got smarter. They said, "Hey, we're tired of being the suckers here. We're not going to buy individual stocks. We're going to start buying funds." Now all of a sudden, it was only professionals who were really dominating the market. Even in the early days, you still had a lot of mutual funds, active managers who regularly outperformed the market.

It seems to me, and you can't prove this, but where that advantage went away was when regulation fair disclosure went out. No longer did the big East Coast shops get first crack at corporate management or maybe get little insights. Once it came out that corporations had to give information out to all participants at the same time, that sort of structural advantage and superior performance that you saw from some big East Coast shops year after year after year started to go away.

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

More importantly, maybe they were also being trained in the same methodology. Now, all of a sudden, when you've got the market dominated by professionals who have access to the same information and are using the same mindset to analyze securities, active management became more and more homogenous. In my mind, that's what really set up the stage for the rise of passive investing because passive investing is simply about keeping your costs down, keeping your transaction costs down, keeping your expense ratios down.

When you're looking at a homogenous group, it's the low cost provider that's going to be the winner there. The great irony is that passive has succeeded largely because active got better. >> I went through the CFA program and it's true that it was a very good program. It produced a lot of good analysts and money managers who were all basically doing it the same way.

>> Before, you had really big shops which had training programs and their analysts all became maybe the equivalent of today's CFAs, but then you had a lot of mom and pop shops and people forget what a cottage industry, the fund industry was 20, 30 years ago. There were all of these small shops and maybe their main stock picker, maybe someone just with drawing out little hand charts and going to the newspaper every day and writing down prices and then trying to do head and shoulder diagrams or something like that.

It was not nearly as sophisticated an industry 30 years ago that it is today. It was as the industry grew in sophistication and became more homogenous that the case for indexing became even more compelling because it was harder to find consistently superior managers because that pocket of underperformers started to be chipped away at.

>> Interesting that you talk about the odd lot trend line and such where the number of odd lots going up, therefore more speculators in the market, that it signals in some way a market top. I recall the number of day traders in the 1990s who you ran into them and they were quitting their day job to become day traders and we were all saying, "This has got to be near a market top." Well, I know it's funny, but you know what, I'm seeing that right now, seeing it right now.

You've got these Robin Hood traders, you've got people who I see on Twitter who just are absolutely convinced that they can outperform the market. I see the same thing that I saw back in the 1990s, the same attitudes, maybe a different group of people, a different generation, but it's the same thing.

We have the rise of the day traders, if you will, supposedly using more sophisticated technology or whatever, but could this possibly be a signal that we're reaching a long-term market top? I don't know. Those are questions well worth asking. The nice thing, though, is that you do see what's oftentimes termed as the behavior gap, the difference between the time-weighted returns and the dollar-weighted returns.

It's starting to really shrink and I think a big reason it's shrinking is that more investors or a higher percentage of investors are becoming buy-and-hold index investors or they're using more sophisticated, longer-term asset allocation plans as opposed to market timing and trying to jump in and out of the market.

The more you just buy-and-hold the market, the more you're going to enhance your returns over time and the more you're going to get rid of that behavior gap because if you just buy-and-hold, your dollar-weighted return becomes essentially the same as your time-weighted return over time. I think we are seeing on the whole, through things like 401(k) plans, the great success of independent advisors out there helping people make better investment decisions, we're seeing on the whole, I think, massive improvement in the average investor's experience.

Your comments about the investor gap shrinking, the performance gap shrinking, your own data at Morningstar shows that people who have been in balanced funds and target date funds or life strategy funds where the rebalancing is done automatically for them is actually a positive performance gap. Absolutely. I mean, you could actually use the bad investor behavior of others against them if you're a bit of a contrarian.

So, in a balanced fund where you're reestablishing the balance, stocks go up, you sell them and you buy more bonds, you're constantly reestablishing that balance and you're going against the fear and greed emotions that investors have. That to me is the central investment question. We know that investors are driven by fear and greed, they have this manic cycle.

I think the question all of us in and around the asset management industry have to ask ourselves is are we going to be a part of accelerating that fear and greed cycle, out promoting hot products at their peaks and then yelling run for the hills at the troughs? Or are we going to be a part of trying to calm down that cycle and help investors ride this out?

And the nice thing is that things, as you mentioned, like balanced funds or target date funds, and anyone working with a good financial advisor is going to get a sophisticated, balanced portfolio based on good, strong asset allocation principles today, all of which are much more likely to lead to a better result.

It's certainly better than calling up your broker 30 years ago and saying, "Hey, what's this week's hot tip?" Well I look at advised client portfolios every day as my business. Now I'm doing an hourly business and so I don't have any skin in the game anymore, I'm not managing money, but I do get to look at portfolios every day and many of them are from advisors.

And yes, there's a subset that does it right, but there's also a subset that is all over the place. That's a very fair point. I wrote a commentary once called "The Third Rail," the thing that no one in and around financial services want to say, and that's that lots of people like to say, "Look how much the average investor underperforms the broad market," but the thing that they never throw in is that the average investor today is using an advisor, because most individuals use some kind of advice or they use something in like a 401(k) plan where there's someone who has a fiduciary responsibility.

And so if you put those two things together, that the average investor is doing poorly and the average investor is working with an advisor, it means that there must be an awful lot of bad advice out there. And at one point there was more bad advice than good, I would argue.

If you turn back the days when the wire houses sort of, their mutual funds were the biggest in the industry and they were some of the worst performers. But increasingly today assets flow to the better funds and increasingly people are deploying them more successfully and they're holding them for longer periods.

They're not just trying to jump in and out. And so I tend to be an optimist and say, "On the whole, things are trending in the right direction," but I would agree with you wholeheartedly and say that we're not at that point where everyone's having a great experience and that there aren't still bad actors out there.

You know, a lot of times we point to fees as the reason why active management underperforms indexing, and then we can look at fees for active management coming down pretty substantially over the past 20 years. The fees for indexing and index funds and passive, the traditional ones as you spoke about, are also coming down.

But the irony is of the data that I look at, even though active management fees have come down quite a bit and traditional index fees have come down some, they were already low to begin with and they came down some more. The number of active managers that are underperforming the indexes is still the same amount.

It hasn't come down. So there's something else going on there and I think the fact is active management is just getting tougher and tougher and tougher, as you pointed to earlier, with the quality of active managers that are out there. It's absolutely true. Another thing is that it's been the biggest companies that just keep getting bigger and bigger that are what's driving the market.

Look what's happened with the FAANG stocks recently. And you think about this, an active manager might easily have three times the market weight in a small cap stock, but they're never going to have three times the market weight in Amazon. You'd have to put a double digit amount of your portfolio into that one stock and no one ever does that.

And so active management tends to do better on a relative basis in small cap led markets than they do in large cap led. And certainly the kind of markets, it's an environment we've been in the last two decades where the biggest keep getting bigger is one that is not advantageous to active management.

And active management, as you point out, doesn't need that disadvantage because it's already at a crippling disadvantage due to cost, especially if you include taxes in cost, which can just completely decimate the case for active management when you take into account the tax consequences of their actions. This is a really good segue into style boxes because you mentioned that the average active manager more equal weights their portfolio than market weights their portfolio.

Therefore they are going to have a higher probability of having more weight towards mid cap and small cap individual names than say the market would. However, years ago you created Morningstar style boxes, which captured this and put these managers in the right boxes, or at least attempted to put the active managers as closest as you could into the right boxes to try to give you a more apples to apples comparison.

So tell us about the whole evolution of the style boxes. Well, it came from attending a financial planners conference and advisors were sitting around the table saying, how do I explain to my client why we have more than one US equity fund in their portfolio? They said the client would say, look, we've already got this one equity fund.

Why do we need another general equity fund? Let's add a gold fund or let's add a sector technology fund. And the advisors were saying, gee, I could see adding a gold fund or a tech fund, but that should be the seventh or eighth fund we add, not the second.

How do we explain to an investor that two US equity funds might be complementary to each other and another two might be overlapping and that the two I'm suggesting actually complement each other and aren't doing the same thing and so it's actually bringing diversification. And what we really want to do is give the investor control over the analysis of their funds.

And back then, some of our rivals in the fund tracking business, they basically just let fund companies pick their category. If they called it a growth and income fund, it went into the growth and income category. And yet, their definition of growth and income might be very different from someone else's.

And we wanted to police that to a certain extent. And we also wanted to get rid of what I call sort of the inside baseball talk. Back then, you had to be an insider to know that Windsor meant large cap value stocks, that that was John Neff's strategy, and that Janus meant large cap growth.

If you were an insider and you knew those things were great, but there was nothing about the name Windsor or Janus that gave you a clue how they were going to invest that money. And what we wanted to do was just create more apples to apples comparisons so an investor could understand, could make better comparisons between funds and could understand perhaps what role in a portfolio or what part of the economy or the economic opportunities a certain manager was mining in, and to set more realistic expectations.

You know, to expect Windsor to outperform in a growth-led market would be foolish. And yet, if you didn't have that understanding that Windsor really bought value-oriented stocks and it had headwinds and tailwinds that were different than Janus, you would end up consistently selling Windsor at the time you should be adding to it and buying Janus at the time you should be selling it.

So we just wanted it to be descriptive and to help people and advisors get on the same page and better understand and set more reasonable expectations for the funds that they were holding. >> About this time, 1994, Gene Fama and Ken French came out with their first section of return paper which talked about the three-factor model, beta, size, value, which was measured by them by book-to-market.

How much did this influence Morningstar's decision to go with a Morningstar style box and how much did that work in? I know that your value is not book-to-market. You have a multi-factor approach to value and growth, but could you explain the academic side to it? >> Well, initially, the way we looked at value was just price-to-earnings and price-to-book.

It was just those two added together, you know, the relative position and then averaged. I think it was a nice correlation. I mean, obviously, we were doing this before they were doing it, but it was already, there was circulation out there and you did have a handful of managers positioning themselves as small-cap value and some as large-cap growth.

But most of the things that were small-cap were on the growth side. There used to be a small-cap category and an aggressive growth category and they tended to have an awful lot of gray area between them. So I think, you know, the academic backup of this thing that, look, size and style are something that has predicted value and are important differentiations.

I think that maybe encouraged more fund companies to pay attention to this. And then the style box also gave, you know, this sort of the unintended consequence of the style box is it gave fund companies a roadmap on what kinds of products that they could develop. Because right now, you know, they could say, we could look at this nine-box grid and say, we've got funds that map into three of these, so now what we have to do is go out and create the other six.

And, you know, that was never our intention. We didn't design the style box to be a marketing roadmap for product creation. We did it for these much more pedestrian intentions of trying to just help investors understand what a manager was doing and to understand that over time a manager's style might change.

You know, someone who starts out buying small-cap stocks, as the fund gets bigger and bigger, might migrate more into mid-cap or large-cap territory. Or you could have a portfolio manager leave. You know, the fund's name would stay the same, but perhaps the last investor was a diehard growth investor and the new investor is much more value-oriented.

You know, back in the days when fund companies just, or funds just had these poetic names, you saw those kinds of massive shifts in strategies that would go on with the investors not, you know, not at all being aware that they suddenly had a very different portfolio. >>COREY: Oh, like the Fidelity Magellan fund.

>>STEVE: There was a, when we first started doing this, there were two funds called Blue Chip Growth, I think. One was from T. Rowe Price and the other was from Fidelity. And T. Rowe has always been a real truth in labeling shop, and so if they call something Blue Chip Growth, it's going to be what you and I would, and your clients would think of as being, you know, Blue Chip, you know, large-cap stocks.

And I remember we looked at, like, the Fidelity Blue Chip Growth fund, and I think it's median market cap, where you placed it just barely in the mid-cap, just out of the small-cap. And I remember talking to the fund manager, and he said, "Well, I guess if pressed, I would have to say that I think of these as future Blue Chips." I said, "Well, that's great, but you're telling the world that this is a Blue Chip fund.

They think their expectation of what they're getting is completely different from what your expectation is in running the fund." And when you have that mismatch of intention and expectation, investors tend to suffer, and I think the industry lets down its clients. >>COREY: And actually, the SEC finally stepped in on that, and was sort of a truth in labeling regulation that came out to ensure that if you said your fund had Blue Chip stocks in it, it had better at least 80% have Blue Chip stocks.

>>GREGORY: Yeah, it's true, but it gets a little nebulous when someone's like, "Well, how do you define a Blue Chip?" There isn't some, you know, God-given stamp that said, "This is a Blue Chip, and this isn't." But you're absolutely right. And there was a classic example. Again, I think it was a Fidelity fund.

They had an insured municipal bond fund, and John Lansner of the Orange County Register did a report in his local paper about what's the exposure to uninsured bonds in all of the different California insured municipal bond funds. And I think then the limit you had to have was 65% had to be in the type of security that your name suggested.

And Fidelity at that time had 66% of its assets in insured bonds, and the other 34% in uninsured bonds. And the manager said, "Yeah, we think insurance is just way overpriced right now, and it's not worth the premium you have to pay for it." Well, that's great, but you're selling this to the public as something that's labeled as an insured municipal bond fund.

And so it still seems to me that while the SEC has cleaned up on this and gone with an 80% rule across the board, there's certain words like "insured" or "government" or "treasury" that really pull on investors' heartstrings. And today, you could put four motor company bonds in a government bond fund and enhance your yield and not be violating any of the rules.

Now, in practice, we don't see that much of that kind of shady dealing going on in the industry today. I think it's a cleaner, better-lit, more fiduciary-centric industry than it was perhaps 30 years ago. But I still think you have to be on guard against that kind of stuff, because, again, when you have intent and expectations varying greatly, investors oftentimes end up disappointed.

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

>>COREY: Another benefit of indexing is the transparency. I mean, you do know what you're getting. >>STEVE: Absolutely. I mean, there's scores of benefits to indexing, and the longer-term view, the tax advantages, the truth in labeling, all of those are there. But that said, there's a lot of craziness under the index umbrella these days.

Anytime something gains popularity and it's got someone like Jack Bogle at the forefront of it, you're going to attract shadier characters around the fringes of that who are going to quote Jack and say, "Oh yeah, following his great tradition, we're launching a set of market-timing triple-leveraged index funds, and these are good because they're index-oriented." They're like, "That's something Jack wouldn't touch with a 10-foot pole.

You really shouldn't be invoking his name on something like that." >>COREY: Oh, I agree. I call it special-purpose indexing, spindexing. That's what it is, just spinning something. I mean, the fact is you create some crazy index based on the shoe size of the CEOs, and whether they're left-handed or right-handed, I mean, whatever it is, you create some crazy index, and then you turn around and you launch an ETF or a mutual fund to that index, and you call that mutual fund passive indexing.

I just think that the industry is getting away with way too much when they start going down the road of calling spindexes or comparing spindexes to traditional indexes. >>GREGORY: Then you go grape yourself in the sacred cloak of indexing and invoke Jack Bogle's name and say, "We're doing the Lord's work." Jack would be rolling in his grave over there.

>>COREY: Absolutely. I want to get into the rating systems that Morningstar uses. You have two different types of ratings. You have a star rating, and you have an analyst rating, so could you compare and contrast the two? >>GREGORY: Well, the star rating is something that Joe had come up with before I joined Morningstar, and it has some positive advantages to it, absolutely.

One would be it's longer term oriented. The minimum period we look at is three years, and if we have a five or a 10 year history, we weight those more heavily. The second thing is that it's risk adjusted, so if you go out and you take a lot of crazy risk, you produce a very volatile stream of returns, one that investors are unlikely to use well, because greater volatility means there's a greater chance you buy high and sell low.

You get penalized for that in the star rating system. The other thing is that the star ratings include all costs that a mutual fund has. It includes the expense ratio, but it also includes front end and back end sales charges. We deduct those when calculating a star rating, and this was a huge improvement at the time it came out, back in the mid-1980s.

Back then, most of the comparisons you saw were things that said, "This fund is number one in its category," and sometimes the categories were very short term oriented. It could be very narrow or very short term oriented. It might be growth in income funds with assets of less than $25 million, and the performance period might be over the last three months.

The other thing is that all of those number one in category comparisons ignored any sales charges that you might incur, so it was something that really camouflaged the impact of cost, whereas the star rating, by including the loads and by taking a longer term point of view where the burden of high expenses takes a greater and greater toll, or at least it's not camouflaged as much as it can be in short term results, the star rating was something that was a real important catalyst in pointing people towards not only better performing, or at least better historical performance and lower risk, but also substantially lower cost funds.

I think that's one of the things Jack recognized right away, and an advantage in what Morningstar was doing, is that we were taking an approach that put more emphasis on cost than the industry had done to date. I know people will complain about the star rating and say, "Well, it doesn't tell you this.

It doesn't tell you that." We always say, "Well, first off, we never said it told you everything you needed to know, but it does tell you some things that are of value," and then some people would come and say, "Well, I think you should just buy index funds and ignore the star ratings." Okay, that's fine, but traditional index funds have substantially and consistently gotten above average star ratings, and people say, "Well, I think you should just buy Vanguard and Fidelity and ignore these other three fund groups." Well, Vanguard has consistently had the highest, or certainly among the large fund families, the highest average star rating, so there's something right about them, but there's also something incomplete, and what we always said is that the star rating is an introduction, not a conclusion.

It's a good place to begin to screen down the universe to a more manageable size, because there are tens of thousands of funds out there. You just can't possibly look at all of them. You need to have some kind of mechanical way of reducing it to a more manageable task.

Then you started analyst ratings, where you gave them gold, silver, bronze. This was more forward-looking, correct? Yeah, and that was the intent. We recognized the shortcomings of the star ratings. In fact, we conceded them before most people recognized it. We never ran an ad that said, "Follow the stars to riches.

This is all you need." Yeah, but there were a lot of ads that said that, but you didn't say it. Yeah, yeah, and again, you have to go back and say, "Well, what would it be better? Would it be better that they're quoting the star rating that's long-term, risk and cost adjusted, or short-term number one in its category, when you don't even know what other funds are in the category, and you know that it's ignored the sales charge?" It was an improvement at the time, but it wasn't everything, and that's why we did the analyst rating.

We knew that we produced a whole page of research, and the star rating was just one of hundreds of data points on there. Oftentimes, our analysts would say, "This fund currently has a five-star rating, but here's the reasons why we would be cautious and wouldn't think that that's predictive of the future.

Perhaps there's been a manager change, or perhaps it's just a three-year record, not a five- or a ten-year record, or perhaps the fund has had a certain tailwind that our analysts thought was unlikely to continue." We wanted to get more of that information into the starting point analysis, because we knew that some people just stopped at the star rating.

That's where the analyst ratings came about. As we built up a global team of analysts that was capable of doing this kind of due diligence on funds, we decided to put more of that into a rating so that people could have something that would be more stable than the star ratings, and it would include more of our best thinking.

Again, we did not adjust a star rating if a portfolio manager left, because you never really knew on the outside how important was that manager, and how important was the team, and all kinds of variables that you didn't know that were very hard to get into a mechanical thing like the quantitative star ratings, but we could get into the more subjective analyst ratings.

That was the intent, was to give investors a better starting point than the star ratings. I'm going to ask the tough question here, because you do have advertisements for mutual funds in your magazines, and in your publications, and such, and they have a tendency to want you to say certain things about them, and to give them certain ratings, and so forth.

There's a pay-to-play element in the financial media that basically you pay us money and we'll say good things about your fund and your fund company. Can you comment, number one, about the whole industry, and number two, about Morningstar's approach to this? We didn't have advertising in our products for a long time, and as we moved into the web, we started taking ads.

The old research publications didn't, but on the web, it's part of the business model. What we did is we said, "Well, look to the people we admire most," and we looked to The Wall Street Journal, we looked to The Economist, we said, "Look, there are plenty of examples where you've got an editorial function that is kept separate from the advertising, and it's just not that difficult to do if you've got the right culture, and you set up the right parameters." We hold our analysts to one standard and one standard only, but the only thing we hold our analysts to is, "Are you telling the story as fairly and accurately as possible from the investor's point of view?" That's the only standard that our analysts are held to.

Our analysts sign their work, it's out there for the world to see, and it's out there with all of the supporting data. Anyone reading this can look and see, "Okay, the analyst says this fund has a consistent history. Well, let's go look at the returns. How consistent have they been?" I think it's as transparent as it can possibly be in a realistic business model for the web.

>> Let's talk about exchange-traded funds. You were around when they launched the first one back in 1994, and I personally started using them in 1996, so there was only two of them. There was SPDRs and MIDIs, but I could see that this was the future. You picked up on that right away also, that this was the future.

>> Sure. Well, you were really prescient, Rick, and you were among the early advisors to really latch onto this, and a lot of advisors wouldn't because there wasn't some kind of a commission baked into it. I think what set you apart is that you're looking at this from the point of view of the investor.

If you were looking at it from the point of view of someone who's trying to make a buck selling stuff, then maybe they weren't nearly as attractive, and that's why they got ignored for a while. We came at it from the same point of view as you did and say, "Look, this is low-cost.

This is good. We don't see the issue." I remember Jack Bogle had a big issue with it. He had his shotgun analogy, saying this is a very powerful tool that could be used for self-defense or for murder and things like that. Then when Vanguard came up with some very creative ways of attaching them or linking them to their existing funds and the tax advantages that they have, they really do have material advantages and the low-cost and the transferability of them to move them from one account to another.

There's some powerful advantages for the investor. We were championing them because our moral compass always pointed to do what's right for the investor. If the investor wins, everyone else in the process can succeed, but if the investor is suffering and not doing well, then all of us have failed to do our job.

I recall when I first started looking into ETFs, it was around 1996 when I had my epiphany, my aha moment, listening to Jack Bogle and reading his books and coming up with why aren't I doing this for my client. I started looking around. I was working at Smith Barney at the time.

I was looking around saying, "Okay, where are the index funds? Where can I find index funds?" Of course, you couldn't find any index funds that weren't available, but by 1998, actually, Smith Barney did launch a clandestine index fund. You could find it if you wanted. We actually had one.

It was buried deep, deep, deep down in the Smith Barney mutual fund platform that was never advertised and nobody knew about it, but it was there and you could use it. It was relatively low cost because they didn't want people running to Vanguard, but the only thing that I really had available was ETFs.

That's where I started putting client money. I remember going to Jamie Dimon and I said to him, he was the president, and I said, "Jamie, we should do this," and he had no interest in it whatsoever. Now everybody's doing it. >> It didn't fit the old brokerage model. >> No, it certainly didn't fit the model because there was no money in it.

There was no 12B1 fee. These companies, Vanguard wasn't about ready to pay any brokerage firm a half a million dollars a year just to get in the door and buy pizza for the advisors and tell them about these things. >> Pizza's the least of what the advisors were asking for.

>> Let's talk about advisors because we're into this. You talked about the evolution of active funds and how it's getting tougher for active managers as the world is getting smarter. What about advisors? You've written a lot about this. In fact, a lot of the audience for Vanguard is advisors.

You have a big advisor conference every year. How do you see that industry evolving and changing? >> It's been a massive change in my lifetime. The first advisor I met was my father's stockbroker. My dad would go to her for ideas on what stock should I buy. The advisors started as people that would pick individual securities.

Then in time, they said, "You're not really very good at that. You shouldn't be doing that. You can't pick stocks, but you can pick managers, so go out and pick active managers." That became the bread and butter trade of many advisors for a number of years. Then, as we've talked about, it got harder and harder to pick successful active managers.

Many asset management shops turned into soap operas. The star managers become divas, and they leave in a huff. All of a sudden, you've got all these tax consequences, and you've got to run and reshuffle. The case for passive investing just became stronger and stronger. The mantra among advisors came, "We can't pick stocks.

We can't pick active managers, but we can pick asset classes. We can pick a whole bunch of indexes, and we can put together a good portfolio." That was the model for some time, but now I think you're even seeing that begin to change and morph. Tim Buckley, the new head of Vanguard, in his first couple of weeks taking over as CEO, he started making some statements saying, "We really don't think advisors should be putting together portfolios.

We don't think they should be in that business. We think they should be buying model portfolios, and that our people can put together these portfolios and manage them and rebalance them better than many advisors can." If you think about it from that perspective, the advisor has been pretty much pushed out of the entire investment part of the investment management process.

The fascinating thing is, even with all of these things happening, the advisor's role and the commitment that clients have to their advisors is as strong as ever, which suggests that in many cases, what the clients really wanted from the advisor was something other than some kind of mythical investment genius.

What they really wanted was some hand-holding and someone to listen to them and someone to match their goals to an investment portfolio. Advisors are doing that today and providing an incredible value for their clients, even if they're not picking the next hot stock or the next star manager. I think the role of the advisor has really shifted phenomenally in the last 30 or 40 years, but the importance that the advisor has for the client hasn't diminished at all.

Most investors want to be working with someone if they navigate these difficult financial planning decisions. Although I see the way that advisors get paid is now becoming more in the spotlight. I've been on all sides of it, Don. I started out in the brokerage industry doing commissions and then went to the AUM, Assets Under Management business.

I had my own advisory firm doing AUM for almost 20 years, and now I'm doing an hourly model. What I see, again, from looking at all these portfolios that I see every day, is I see advisors who want to get assets under management. They do things that sometimes I don't agree with.

Just yesterday, I was talking with a client, and his advisor had him roll money out of a 401(k) into an IRA that the advisor could manage, and then when the client got another job at a company that had a very, very good, low-cost 401(k), he didn't advise the client to move that money into the new 401(k) because he would have lost the assets under management.

That precluded the client from doing a backdoor Roth and a mega-backdoor Roth, and it was paying management fees to this advisor. In other words, the incentives of AUM to the advisor caused the advisors not always to make the most fiduciary decisions for the clients. Yeah, I think you're right.

There are issues. On the other hand, I think most clients prefer it, not having to write out a check, have it collected seamlessly, and from the advisor's standpoint, it's delightful. If you can get paid in basis points, what a wonderful way to earn money. I remember one of the first fund managers I ever saw speak was a guy named Tom Ebright who ran money for Chuck Royce, and I remember him saying, "I get up in the middle of the night, and I go to the bathroom, and I'm making money.

I'm getting paid. I'm getting paid around the clock all the time as long as that meter is ticking on the AUM fees." If you're getting paid on assets under management, you have very little incentive to leave it, and as a client, even if you might look at it and say it doesn't really ...

There may be some issues that are bad. Most people prefer to pay in this seamless way. That said, I think there are two things that the industry really needs to think about is that the AUM model does not work at all for the small client, nor does it work well for the large client.

For the small client, if they don't have any assets, then there's no incentive for financial advisors to reach out and help these people. That's a major issue that's going to have more and more attention over the next couple of years. How do we reach out to underserved communities? How do we make more people in America investors, or how do we help small investors become more meaningful investors, and how does the financial planning community reach out to these underserved communities?

Then, on the other hand, advisors have their very successful clients who may now have tens of millions of dollars. Maybe they've sold a business or something like this. Well, for them, paying a percentage of assets under management is a huge, huge check that they're writing, or they're not even writing it, but they're paying each year, and as they wise up, I think a lot of these people would come back and say, "Hey, let's negotiate a flat fee.

That makes more sense to me." AUM doesn't work from the advisor's perspective with small clients, and it doesn't work from the client's perspective with large clients, but for the vast majority of people that the planning community works with, even though there are issues that you correctly point out that can create, perhaps, false incentives, I think it's one that's sort of a preferred methodology or preferred method because of its seamless nature for most participants and most advisors.

Well, we could have a long discussion about that, but ... Well, I'm arguing we're going to an hourly thing. Oh, it's not easy. I prefer that, though. It's certainly not easy because you're only getting paid for the work that you do. It's not like that other advisor saying, "Hey, this is wonderful.

As I'm sleeping, I'm making money." I mean, is that what a fiduciary would say? Well, exactly, and you don't pay your accountant that way. You don't pay your tax advisor. You don't pay your estate planning attorney that way. I mean, I do think that the trend is going to be in that direction, but given that AUM is so set up and so established, and clients aren't rebelling against it, and for most clients it probably wouldn't mean a major savings that they did that.

It might just clear up some of those potential conflicts. I just don't know if there's a catalyst for moving away from it, but I certainly agree with you philosophically that if you paid on an hourly basis, it would probably be better for the client. Let's talk about something that is a move away from at least high-cost AUM, like 1% or so AUM fees, and that is the robo-advisor trend.

Vanguard just launched a new robo-advisor, a true robo-advisor. They have the PAS program, which is 0.3% when you're talking to an advisor. You get the same four-fund portfolio, but you get to talk to an advisor, and now they're at a 0.15% internet-only advisor program where you're not talking with anybody, but the cost of just getting a portfolio managed using a robo-type platform continues to come down.

I think this is a good thing. I mean, there are many more people that need financial planning that are getting it or need investment advice that are getting it, and there are big audiences that the planning community just has to kind of turn their back on because it doesn't make economic sense to serve them.

So the small investor with a 401(k) plan, if they can tap into some robo-advice and have a more diversified portfolio and build up a bigger nest egg until they get to the point where a financial advisor would take interest in them, and also before they get to the point where they've got the more sophisticated questions that an advisor can really add value on -- things about tax decision or charitable giving or estate planning and all of these -- the world of different things that advisors bring to the table.

I think this is a good thing. So I don't see it as a threat, I just see that there's more work to be done, more people that need some kind of help, and that these are going to be a big part of the future. And I do think that the biggest robo-advisors are not going to be some kind of high-tech startup.

It's going to be Vanguard, and it's going to be Schwab, and it's going to be people that already have assets under management and can layer on these additional services at a low cost to the asset management service they're already providing. They're going to be the big players here. One new type of indexing that's available -- it's actually been around for a long time, but it has become more popular lately -- is direct indexing, which is building your own portfolio of 500 stocks, and then selling off individual stocks that are at a loss so you can generate tax losses, which you can use against capital gain that you might have from selling a business or something, or a single-stock position from RSUs or whatever you have.

And this is a growing business. What are your feelings about it? I have mixed feelings about it. Well, I think parts of it are really cool. I like the idea. I also suspect it's more sophistication than your typical investor needs or wants. But the great thing to me is you're seeing a spectrum of opportunities, and you can decide to invest at whatever level of complexity that you like today.

You can do one-stop shopping, just buy a TargetAid fund or a balance fund and just leave it there, or you could assemble a portfolio of individual funds, or you can just buy an index fund, or you can create your own index. I mean, there are just so many good solutions out there, and you and your advisor just have a decision, what complexity level do we want to play the game at?

And I think that's a wonderful thing. So I think direct indexing can be a very good thing, but I think most people come to mutual funds because they want it to be simpler, and they're not looking to add complexity. But there are some cases where, as you point out, perhaps you've sold a business or you're selling a business and you've got a lot of capital gains and you want to find ways to offset them, but look at how tax-efficient a broad-based total market ETF is today.

What kind of additional benefits are you going to get from direct indexing, and do the costs perhaps outweigh that? Those are open questions. But the nice thing is that we're competing on what's a better offer for investors as opposed to what's a better deal for those people trying to sell you an investment option.

So I see that as being on the positive side of the ledger. Let's talk about ESG, environmental, social, and governance, and the kind of the start and stop that we have seen in this over the years. We've had social responsible that sort of started and then it stopped. Now we have ESG, which seems to be getting traction in this social environment that we're in.

Do you think this is it? Do you think it's going to grow now? I do. I'm in favor of this. I think it's a good thing. And to me, it gets back to investor rights. And I think in the early days of Morningstar, what we were fighting for is that investors had a right to know how their money was being managed, what the costs were, who the portfolio manager was, what the fund was actually doing.

And I think today you can extend that and say, look, as an investor today, you might have concerns that go beyond just your mercenary ones and beyond just finances. You want to know what impact your money is having on the world around you. And you shudder at the fact that maybe you're making a profit from a company that's out polluting the environment that your children and your grandkids are going to live in in the future.

And so I think investors have every right to know what impact their money has. So more transparency, more data on environmental governance, social issues, I think these are positive trends. And I do think we're going to move from more of a shareholder oriented focus to a stakeholder oriented focus, simply because the shareholders have needs beyond their financial ones.

They have concerns about the environment, about society. And we're seeing that with young people very much today. My son, he buys stocks, he buys funds, but he does a lot of due diligence, or he does as much due diligence, I would say, on the ESG factors as he does on the financial ones.

And I think that's a trend that's going to stay. And I think it's all about investor rights, that you have a right to know what impact your investments have on the world around you. Money is a means to an end, it's not just a goal in and of itself.

It's not some game where whoever ends up with the biggest pile of greenbacks wins and everyone else loses. It's about reaching your goals and defining your own success. And if being a participant in a process that makes the world more the kind of world you want to live in, that's a very viable concern for your money.

Let's talk about a couple more topics. One of them is fixed income. So we've reached an interesting place in history here, where interest rates are going to remain very low for a very long period of time. In fact, the Federal Reserve is changing the way they operate relative to inflation, where basically going to let inflation rise, as opposed to trying to cut off inflation to make sure that it doesn't get above their 2% target.

Now, these are all big changes to a financial system that are going to cause and are causing valuations of all asset classes to change. I want to hear your feelings about what you think this all means. Those are great questions, because it potentially means that any kind of backward-looking asset allocation and research that we do may be of very little utility, because we're entering into a future that's going to look very different from the past.

And the same thing happened when we went off the gold standard. And you need to think about what are the implications of that, because suddenly fixed income returns may look very different than they have in the past. Certainly, the benefit of being in fixed income today is much harder to make a pound-the-table argument for.

If you can get a higher yield from buying the S&P 500 than you can from buying a lot of bond funds, especially if you're looking at a high-cost bond fund and a low-cost S&P index fund, it's kind of hard to make the case that we need to be in fixed income in a major way.

And I understand that responsible advisors and Vanguard and others still make the case that you need fixed income. And I don't disagree with that, because it certainly adds balance and maybe gunpowder or something or firepower for the future to the portfolio. But the benefits of fixed income, it's hard to see how you can use that as a major asset towards wealth creation going forward.

And it has been an enormous engine of wealth creation for the last 30 years. I don't see how you can argue it's going to be that way for the next decade. I know. It's going to be tough. And a lot of people who are retired and relying on fixed income, or if they're going to annuitize their lump sum, the payouts are going to be smaller.

It's pushing people into more risky asset classes, and that could have consequences also. It certainly could cause the market to go to P/E levels that we hadn't seen in many, many years. Exactly right. And the net result is that the investor will be exposed to greater risks because of it.

And some of the things that people had counted on for their retirement years, the ability to, say, lock in a rate of return near the 4% to 5% rate, which would get you those long-term stability of assets that you need in many of the retirement models, you're not going to get that from fixed income.

You're only going to get it from taking higher risk. And that's a dangerous position to be in when you've got the baby boom generation on the cusp of retirement. Yeah, absolutely. One final item, and that is cyber currencies. How long do you think it will be before cyber currencies make their way into Schwab, Fidelity, Merrill, where they become part of the asset mix for advisors and investors?

You know, Rick, I'm not an expert on this, so please take whatever I say with a huge grain of salt. I would say that, you know, currencies aren't something that investors have used successfully in their investment programs historically. So I don't think that aspect is going to become a huge one.

What I would say is that you'll probably see, you know, there'll be maybe early adopters. I think there are some benefits to these. My guess is that you'll see Vanguard be among the later ones. They'll let others go out and test the waters. Most asset firms that I talk to, they're interested in the technology behind cybersecurity for internal processing, for a lot of different things.

But cyber securities as an asset class, I think, have a long...are probably something on the horizon. But we have a long way to go before you can say that investing in those is a well-researched, responsible choice, you know, something that sort of would fit the prudent man rule. And my guess is that a firm like, say, Vanguard or T.

Rowe that, you know, tend to be more conservative will let some other firms, you know, go out there and test the waters first. And change always happens at the margins. It's not the established players that are the first to embrace a new technology. It's some that come along and embrace it, and some get burned, and others figure out ways to make it work.

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

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

It's like their Pokemon games that they've been playing for years, right? Exactly. Only this is a 24-hour-a-day, seven-day-a-week market, and it's all done through cyber currency. So that's what I envision. It could happen. And the thing, you know, when you and I got into this business, would you ever have imagined ETFs and the range of choices that you have in them, and what a great toolkit the investor today has, compared to what we had 30 years ago?

Today, the toolkit that the investor has is phenomenal. The number of quality, low-cost, high-quality options that are out there for investing is staggering. I mean, today, the individual investor has the tools that only the most sophisticated pros had 30 years ago. So I think it boggles our mind what might be out there 30 years from now, but I can tell you the one thing I do know is that the things that win are going to be those that serve investors well, and the failures are going to be those things that over-promise and under-deliver and disappoint investors.

Don, it's been a real pleasure having you on "Bogleheads on Investing." Thank you so much for your time. Rick, thank you very much. And my heart goes out to the Bogleheads. I think you guys are just phenomenal, and I know how much the Bogleheads meant to Jack Bogle, and Jack is one of my great heroes.

I saw how touched he was by the love and the affection that the Bogleheads poured out, but more than that, I think he'd be incredibly proud by the work that they continue to do, and being out there and being advocates for better investor outcomes, and that's something that I know he would share.

Thank you. This concludes "Bogleheads on Investing," episode number 25. I'm your host, Rick Ferry. Join us each month to hear a new special guest. In the meantime, visit Bogleheads.org and the Bogleheads Wiki. Participate in the forum and help others find the forum. Thanks for listening. (upbeat music)