Don
Phillips interview, July 12, 2002
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On the July 12, 2002 broadcast of Wall $treet Week with FORTUNE, co-hosts
Karen Gibbs and Geoff Colvin sat down with Don Phillips, Managing Director
of Morningstar. A transcript of their conversation:
KAREN GIBBS: Well, nothing has more cachet in the mutual fund business
than Morningstar's famed five-star ratings system, so ingrained in the investing
culture that few people buy a mutual fund without checking the ratings first.
So you can understand the nervousness when Morningstar changed the way they
rate the more than 10,000 funds. But there's good reason for the change the
folks at Morningstar know something you're probably not aware of about the ratings
system's ability or inability to predict future performance. You may be shocked
to learn that one-star funds have outperformed five-star funds 45 percent of
the time since 1995. Confused? Seeing stars? Let's get help from Don Phillips,
Managing Director of Morningstar. Don, thanks so much for joining us.
DON PHILLIPS: Sure, Karen.
GIBBS: Well, why the change, and what do you hope to bring about by
it?
 PHILLIPS: Well, the major change is that rather than rating funds in
broad groups, say all domestic stock funds together, we're going to rate them
across much more narrow groups so you get more of an apples-to-apples comparison.
In many times in the past the ratings worked exceptionally well, but you get
times where you get huge changes in the market where you move from growth being
very much in favor to value being very much in favor, and then you end up with
oddities. For example, back in 1999, 75 to 80 percent of the large growth funds
received four- and five-star ratings simply because large growth had had better
returns over the last decade than had value. And now what we'll be doing is
looking just at within the large growth category or just within the small value
category and assigning ratings within them. And we really hope the upshot of
this is that it will make investors more willing to step up to the plate and
buy a quality fund in an out of favor part of the market.
GIBBS: But won't it make them even more confused now? More categories,
a switch how are you going to deal with that confusion?
PHILLIPS: I think this actually eliminates confusion. What we've had
is a lot of advisors over the years who have said, "I love Morningstar. I tell
my clients great things about Morningstar. But I've put together a truly diversified
portfolio for them." Say it's 1999. And they'll say, the client will see the
five-star rating on the growth fund and say, "Absolutely I'll buy that." But
then they'll see a three-star rating on the Small Value Fund and say, "I don't
know about that." And then they'll see a two-star rating on a gold fund, for
example, and say, "Absolutely not." And yet it's the quality funds in the out
of favor areas that really oftentimes are what bring the most value. Like Jean-Marie's
gold fund coming back so strong. You know, that's a great gold fund. Even at
times when it's out of favor, that's maybe when you'd most want to add it to
your portfolio. Under the new system, we think it will encourage investors to
do that more.
GEOFF COLVIN: Let me see if I've got this right, Don. So that means
that a fund that's in a sector that in general hasn't done well would still
get a high rating if it has performed better than the other funds in that sector.
PHILLIPS: That's exactly right. So some areas that have been very out
of favor right now, like high-yield bonds or especially communications funds,
now we'll be giving five-star ratings to 10 percent of those funds; four-star
ratings to 22.5. And we really hope, we want to get to this issue of helping
people put together better portfolios. You know, I look at the fund landscape
the problem isn't that people buy bad funds today, but they buy a series of
good funds that happen to do the same thing. And because of that, they assemble
a bad portfolio. What we want to do is elevate the debate away from good fund/bad
fund towards appropriate or inappropriate use of a given fund for a given investor
with a given goal.
COLVIN: So if I've got this right, your new system would, among other
things, encourage investors to take a more long-term view.
PHILLIPS: Right.
COLVIN: Because they'll buy funds that may have not performed, from
a sector that may not have performed well in the past, but in the cyclical nature
of things will probably be well managed for the future.
 PHILLIPS: Absolutely. And we've always taken a long-term view. The minimum
period that we rate a fund for is three years. So if you think about it,
we're cutting fund managers much more slack than they give corporate America.
I think the only way you can really evaluate a manager is over an extended
period of time. You can't go in and say, "Gee, this fund didn't do so
well this week. The manager must not be doing a good job." In the short
term there's a lot of noise in the market. What we want to do is encourage
longer-term thinking and to keep reminding investors to think about risk
and to think about cost.
GIBBS: Well, there are going to be some funds that have enjoyed
a nice ride and are going to lose a star, and there are going to be some
that have been out of favor and may gain a star. Can you give us some
examples of those?
PHILLIPS: Well, for the most part the funds that will be losing stars
right now are the ones that have been, that have had their asset classes most
in favor. So, for example, small-cap value, which has had a great two to three
year run now, right now under the old system, over half of the small value funds
were getting five-star ratings, which is very analogous to back in 1999 when
so many of the large-cap growth, tech-heavy funds got top ratings. So some of
those will be losing stars. But as we've talked to the managers, many of them
say this is actually a very good thing. You know, while we don't like losing
stars, the nice thing is that now, because we're in a category, like small value,
that doesn't move a lot like the general market, now instead of going from looking
very out of favor, say getting a two-star rating in '99, and then very much
in favor, a five-star rating today, now they'll have much more of a steady performance,
say a four or five- star, and hopefully that will keep more investors on board.
GIBBS: Can you give us some names of some funds that you think are up
and coming?
PHILLIPS: Well, there are several funds that we like. One would be Dodge
& Cox International. I really like the international area. You investors have
not been looking at international. You've had such a strong dollar over the
last seven or eight years. So many people are saying, you know, "Gee, I haven't
felt the need to have that in my portfolio." But I think there's tremendous
need to have international in the portfolio. Maybe it's because the first fund
I ever owned was the Templeton Growth Fund, which is a great international fund.
GIBBS: But now what happens if the U.S. economy slips and those international
economies fall along with it?
PHILLIPS: Well, certainly that might happen. But I think it's the reason
for diversification. All of the opportunities are not going to be in the U.S.
I think we got sort of myopic during the '90s because tech was so great and
the U.S. dominated the tech scene. We were thinking all of the great companies
were here. Well, there's no reason that all the great companies are going to
be limited within this border, and the more you diversify, the better your portfolio's
likely to do.
GIBBS: Other than Dodge & Cox, give me another up and comer.
PHILLIPS: Well, another fund that we like is the William Blair Small-Cap
Growth Fund. Our analyst, Emily Hall, is very impressed with the team there.
She thinks they do a terrific job. And they've got a bit of a contrarian streak.
One of the problems you get with a lot of growth funds is they just tend to
be very momentum oriented. You see lots and lots of the same names in every
growth portfolio. Well here's a group that really does great independent research,
has a bit of a contrarian streak, and we think it might have a good place in
an investor's portfolio. Today is not the time to forget about growth.
COLVIN: Absolutely. Let's look at the other side, Don funds to avoid
right now.
PHILLIPS: Well, a couple of funds that I don't like are funds that have
very volatile performance and high cost. Especially I think investors have to
be attuned to what risk is in their portfolio. So a couple of funds that I don't
care for that much, one would be the American Heritage Fund and the other would
be Berkshire Focus. And I guess what I don't care about them is that they've
got names that are very soothing. You know, American Heritage, Berkshire Focus.
You might think Warren Buffett had something to do with it. The reality is he
has nothing to do with the fund. These are funds that are very concentrated
in some very volatile stocks. There are times when they'll pop up on the leader's
list and they might look like, hey, these are great investments, but if you
look at them they both have very high expense ratios and the name, which may
be soothing, really isn't what you're likely to get in the portfolio.
GIBBS: What do you look for in a fund manager? What stands out, and
who do you see as fund managers that are on the horizon that we should keep
an eye out on?
 PHILLIPS:
Well, what I look for in a manager is passion. You know, Warren Buffett
used to talk about the one-question job interview are you a fanatic? And
that's what I look for and what our analysts look for in different funds.
And you hear them talking, coming back from an interview, and if they
really like the manager it's because the manager just loves what he or
she is doing and has a real passion and enthusiasm. And that's what we
look for, because the best managers are going to be people, you know,
that do this 24 hours a day. You can't turn them off.
COLVIN: Like who?
PHILLIPS: Well, I think Jean-Marie Eveillard is a terrific example.
You've got people that absolutely love what they're doing. You look at Fidelity,
you look at a number of the managers there, and they've done a great job and
they've got people that love this. You cannot stop them. They'd be doing this
on their own even if they didn't have the job, getting paid to do it.
GIBBS: You also mentioned growth funds. Do you see any growth fund managers
that you think might be worth looking at?
PHILLIPS: Well, one of our longstanding favorites in the growth area
would be Foster Friess at Brandywine. Again, that passion for what he does and
the way that he looks at portfolios, and he's assembled a terrific team to do
that.
GIBBS: Any other examples of fund managers and what they can do for
the individual investor?
PHILLIPS: Well, you know, that touches on a really important point.
One of the things that concerns me is that mutual funds have a great opportunity
to be the voice of the individual investor to corporate America, and I'm not
convinced that that's happening as well as it might. And when I talk to some
CEOs, they'll tell me that groups like Fidelity are so rigorous in voting their
proxy statements and are really out there fighting for the investor. But a lot
of that happens behind closed doors, and I think right today where you've got
a bit of a crisis of confidence on Wall Street, it's more important than ever
that the fund industry be out there and be very vocal and show the world that
they're really fighting for investor interests. I think they're doing it, but
it needs to move from behind closed doors out into the limelight.
GIBBS: Don Phillips, thanks so much for joining us.
PHILLIPS: Sure, Karen.
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