The man who knows why many funds goofed


DON PHILLIPS has a lot of explaining to do these days.

The managing director of Morningstar Inc., the Chicago-based data firm, has been on the road almost constantly since his firm announced plans to change and revitalize its star ratings for mutual funds.

Mostly, he has been talking to fund companies, who want some idea of how their fortunes might improve or decline when the new rating system is in place come July. During a recent stop in Boston, Phillips took a break to meet with me.

Since becoming Morningstar's first-ever analyst in 1986, Phillips has become a central figure in the world of mutual funds. The firm he has helped build, in turn, has shaped investors and their expectations.

Phillips is both an advocate and a critic of the fund industry and its major players.

Never bashful about expressing his opinion, Phillips voiced some beauties over dinner. Today, and again next week, this column will feature the highlights from our conversation.

On the evolution of the fund industry: "The role of a fund has evolved from being your investment portfolio - pretty much all you would own was one or two funds for all of your needs - to fitting one little slot in an overall investment portfolio.

"As a result, the asset-allocation decision has been transferred from the fund manager - who used to decide where best to invest rather than sticking with one narrow category - to the individual or their adviser. I'm afraid a lot of people still don't get that.

"I talked to a lot of investors who during the bull market said, 'If we get a bear market, I certainly hope my manager is smart enough to go to cash.' Yet I had talked to their manager the week before and he was saying, 'My job is to stay fully invested in stocks at all times.' Managers were assuming that the buyer had made the decision to buy the fund because they wanted stock exposure."

On lessons from the bear market: "In the 1990s, everyone was brave, which is an easy thing to be in a bull market. Now, in a bear market, people are realizing that they completely misdiagnosed their risk tolerance.

"If you learn that about yourself, then the asset allocation you set for yourself in the bull market is not the one you need to have going forward. ... Getting the right allocation will make you a better investor."

On Morningstar's new rating system, and whether it will encourage firms to close bad funds: "Most firms hang on if they have a glimmer of hope of obtaining a good record and obtaining a sizable amount of assets under management.

"There certainly are fund companies out there that say, 'Better to bury our mistakes than to let them become part of the permanent record.' Maybe the new ratings, which we think will be more stable, will convince them sooner that they have no hope. I don't think that would be a bad thing for investors."

On what he would change in the fund industry: "The major thing would be to get this notion of trusteeship back into the industry, the idea that the fund shareholder is the owner. The [Investment Company Act of 1940] goes out of its way to put the investor at the top of the pyramid, as the owner, with the fund management company as the employee.

"Fund companies have inverted that to say, 'We'll create a product and sell it through supermarkets or other distribution networks to customers.' That structure sort of puts the investor at the bottom of the pyramid, where they are at a disadvantage."

On funds disclosing complete portfolio holdings just twice a year: "Fund companies will bare their entire portfolio to an institutional investor at the drop of a hat. So why turn around and make it so difficult for individuals to get this information? ... I'm suggesting they could post it on a Web site, with an appropriate time lag, allowing for better research and analysis and creating a better paper trail for who owned what.

"Right now, look at Enron. There is no real paper trail saying who still owned it in October. You look at funds that publish their portfolios at the end of June and the end of December, and they say 'Oh yeah, we got rid of that in early July.' "Well, I'd like to see that to know for sure."

Speaking of Enron: "Fund managers should have known, especially ones like Janus who run ads saying, 'We climb down into sewers to get the inside scoop.' If you are out there boasting that you do really solid fundamental analysis on companies and you weren't reading the footnotes and didn't pick up on this, I think that's a black eye."

Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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