On this episode of The Long View, we chatted with Don Phillips, a managing director for Morningstar who joined the company in 1986 as its first mutual fund analyst. He discussed investing culture, stewardship versus salesmanship, and how to choose a financial advisor.
Here are a few excerpts from our conversation with Phillips, who helped develop the Morningstar Style Box, the Morningstar Rating, and other proprietary innovations that have become industry standards.
‘Private Credit Doesn’t Understand Retail Investors’
Amy Arnott: A topic we’ve been hearing a lot of buzz about lately is private assets, so private equity and private credit. There’s been a pretty big push to make things easier for plan sponsors to add those types of assets to 401(k) plans. What are your thoughts on encouraging broader adoption of those types of assets in retirement plans?
Don Phillips: Well, I think I’m going to see more and more of this, but to me so far, there’ve been a number of pratfalls. I mean, you look at the Blue Owl situation, and right now there’s a bunch of name-calling going on. I mean, people pushing the blame on the other side. One of our executives was at a private credit conference the other day, and he came away and said, “They just keep talking about how wrong individual retail investors are. They just don’t understand private credit. What’s the matter with them? These gates are really for their own protection. It’s a good thing.” And the other day, a very senior tech executive said, “The problem is that retail investors just don’t understand private credit.”
But I think it goes the other way, too. Private credit doesn’t understand retail investors. Retail investors, if you look at managed investment products over the last hundred years, you move from unit investment trusts to closed-end funds to open-end funds to index funds to ETFs, the whole move, every move has given investors either greater diversification, lower cost, or more liquidity. And now, all of a sudden, you look at private assets, they move against all three of those trends. There are going to be higher costs, they’re going to have less liquidity, and they’re going to be more concentrated. They’re not going to have the diversification of a broad market index. So, everything retail investors have been trained on for the last four or five decades, as this has really become the starting place for building portfolios, now the industry is reversing course on all of those things, and they’re wondering why investors aren’t prepared for this.
So, you look at, say, now fixed income, what happened with Blue Owl, for example, the roots of fixed-income investing in the mutual fund industry really came from the money market fund. You go back to the ’80s, and most of the money, the personal savings, was in banks and passbook savings accounts paying 5.25%. And it was when money market funds could offer a double-digit yield that they were able to pull people out of the banks into the mutual fund industry. Money market funds were the calling card that got a lot of investors into mutual funds. And then when money market funds’ yields went below 10%, then the industry migrated them to government-bond funds with much longer maturities, and then they moved them to corporate bond funds, and then to high yield. And it’s been a move down where you’re always taking on more and more risk, but the mindset has still been about this is like a money market fund.
And you think about mutual fund, bond-fund namings, they always highlight the most comforting aspect of the fund, not the most salient. I mean, no one ever bought a “low-credit-quality bond fund.” You bought a “high-yield fund.” And if you see something that’s called an “investment-grade bond fund,” well, we know that’s a euphemism for single A. And most investors, they don’t know that, well, there’s single A, and then there’s AA, and there’s AAA—that it’s more middle of the pack, perhaps, if it’s called that. That, I think, is the issue. And the industry plays up, in their marketing, the safety and the security. Think of government-bond funds that have pictures of the flag festooned all over the marketing materials and the shareholder reports, and the Capitol dome, and yet now all of a sudden you’re in things where you are taking credit risk, and there’s nothing wrong with taking credit risk if you know you’re taking credit risk. And unfortunately, the industry tends to soft-play that information that you need. I think that’s why people were really surprised with Blue Owl because their expectations were—this is like a money market fund; you shouldn’t expect it to break the buck.
Now you’ve got the private credit people saying, “Well, it’s not that big a deal.” And you could say the same thing about a money market fund, right? It goes from a dollar to 99 cents. It’s not the end of the world, but it broke the buck. You broke the promise or the expectation that you had created. So, it’s a first date for both sides. Retail investors are new to private equity. On the other hand, these private securities offerings, they don’t really understand the retail mindset.
And what we can just hope for, and what I think Morningstar is working for, is how do we increase the odds for investor success here? Because in the long run, if the investor doesn’t win, both parties are going to suffer. So, trying to get a successful first experience and then build from that is, I think, the most important thing, as opposed to how do we get assets into this as quickly as possible.
‘Investors Benefit From Well-Lit Playing Fields’
Christine Benz: With privates in the hands of retail investors potentially, what do you think of the Bill Bernstein argument that the lower-quality players will be the ones who are willing to sell to the retail space and that the better private operators will stay where they are and not be in the retail space?
Phillips: Well, there’s certainly that possibility. You certainly look at what happened with the hedge funds and how many financial advisors wanted to mimic the Yale model, but they didn’t have access to the same caliber of hedge fund that David Swensen had, and said they were buying retail offerings that may have been done by lesser players and certainly with higher fee schedules. So, you always have to look at that sort of thing and where the innovation is coming from. I think Bill’s almost always right about these things. I think that is a good insight, but it’s going to happen. You’re going to see more of these things happen.
One of the things that worries me a little about this whole love of private investing and people want to get to SpaceX and a couple of situations like that. One of the things I think we’re forgetting is just how good public markets are, how beneficial they are for investors.
I remember before Morningstar went public, Joe [Mansueto] talked about it and said, if we go public in the US markets, we are accepting the highest level of transparency and accountability anywhere on the planet. This is the cleanest, best-lit playing field, and investors benefit from well-lit playing fields. And now people are saying, well, we have to find ways that private equity money can tap into retail money so they can get the benefits of being like a public company. But I think we should also think about things we can do on the public company side to make it easier to be public, to make the reporting a little less onerous, to make more companies want to be public. Because the ultimate goal, I think, for investors and the investment community would be to have more companies in the public arena where the sunlight is better, rather than now more of this moving to the shadows or the sidelines.
But it’s going to happen in some ways, and there’ll be compromises on both sides, I guess. But one of the things that clearly is going to happen is that the investors’ toolkit is going to get wider and wider, and that’s a positive, but it also means that there’ll be challenges in how to navigate some of the new things that are coming in.
‘It’s All AI-Oriented, All Tech-Oriented’
Arnott: Something that Morningstar has always put a lot of emphasis on is actually looking at what’s in fund portfolios, which, when you first started, people, to the extent that they could even find information about funds, they would be focusing on returns. And I think Morningstar was really the first company to put so much focus on what’s actually in the portfolio.
Phillips: The vast majority of fund analysis before Morningstar was really a form of technical analysis. You were looking at the shell of the fund, its price and dividends, and then how that moved. And without understanding what built that, what was the cause of the performance? And without doing that work into what the fund’s actually investing in, you can’t understand headwinds and tailwinds. You can’t understand why this fund succeeded at one point, and another fund, a different fund, and you can’t even begin to put together intelligent portfolios. If you just buy a bunch of funds that have all succeeded in the recent past, say, buying off of last year’s leaders list, almost definitionally what you’re doing, you’re creating a false sense of diversification because you’re layering a bunch of different funds, maybe with different names from different organizations, together, but because they all succeeded at the same time, it’s very likely that they’re investing in essentially the same things.
And so you get this false sense of diversification. You think you’re diversifying, when in reality you’re just multiplying your bet. And that’s something I’m really worried about right now with private equity. I had a conversation with Kunal Kapoor recently, who said he had talked with Bill Nygren from Oakmark, and Bill was saying how the S&P 500, we think of it as the broad market, but it’s become very concentrated because of the Mag Seven, certain sectors, a handful of companies really dominate this, that he thinks of the S&P 500 today as a much more concentrated bet than it’s been historically. And I think the irony right now is that you’ve got a lot of individuals and maybe financial advisors saying, “Well, we’ve got a lot of people in conventional S&P 500 broad market type investments. We need to diversify. Well, let’s go into private equity.”
Well, private equity may be trading differently, but the private equity world is a herd mentality. No one’s buying concrete companies in private equity funds. It’s all AI-oriented, all tech-oriented. So, you move into private equity today, the odds are that you’re actually concentrating the bet that the broad market of publicly traded stocks is already making. You have this illusion of diversification. And again, there’s nothing wrong with running a more concentrated portfolio, except that if you think that you’re diversifying when in fact you’re concentrating. And we do know that, historically, investors have used concentrated portfolios less well because their performance tends to be more extreme, and so people are more likely to be tempted to buy high and then to sell low.
And the whole talk about private and public convergence, talk to some of our people that deal with Washington, and the regulators are very focused on liquidity, and they’re very focused on cost. But I think one of the things we really have to think about is concentration.
That’s a risk that is embedded in private equities because of the herd mentality there. You’re going to be much more sector-concentrated and perhaps much more concentrated in a handful of names like a SpaceX or something that dominate those indexes. And we know that concentration is something that routinely investors find very difficult to deal with. They don’t use concentrated funds well. And when we’ve looked at investor returns, and Amy, you’ve done seminal work on this, you realize that some of these more concentrated funds that soar very high and that come down very hard, investors really don’t use them well. And some have amazing paper records, but if you dig a little deeper, you realize that they’re actually costing investors money because investors time their purchases so poorly.
Arnott: And with private equity, you have concentration on the investment side, but then you also have tremendous dispersion on the fund side, where there’s a big gap between a top-quartile vehicle versus the bottom quartile. So, that could lead people to have even worse experiences.
Phillips: Terrific point.
Valentina Djeljosevic contributed to this article.