John Rekenthaler, research director of Morningstar of Chicago, has been an observer and occasional critic of mutual fund industry practices in his online columns for the fund tracking firm at Morningstar.com. Rekenthaler, who will speak on investment advice at the Investment Company Institute's general membership meeting this week in Washington, D.C., discussed fund industry issues with Mutual Fund Market News reporter Mike Garrity. An edited account follows.
MFMN: Do you think funds are becoming passe?
Rekenthaler: No. I don't think funds are becoming passe. It's clear that funds are no longer chic. In the early 1990s, funds were the hot new thing. Of course mutual funds weren't new, but they were new to the mainstream populance in the late 80s and early 90s. They hit the big time. There was a thrill factor associated with mutual funds a decade ago.
I know this because I worked at Morningstar then. When I met people they said, "Morningstar. Mutual funds." Their eyes would light up. They wanted to get advice on what mutual funds to buy. There was a buzz about the industry.
Now, when I meet people, I say Morningstar and they say, "Oh Morningstar, mutual funds, huh." They think for a little bit and shrug and move on. If they thought I could help them pick an Internet stock or a technology stock, they'd be all over me.
Funds have gone from being perceived as the hot and sexy way to make a lot of money to being reliable and dull, responsible places to put your money. It's not all a bad thing, the image that funds have settled into. Reliability is a great attribute. People are putting a lot of money into funds. But it's what you do in your 401k plan and sort of forget about as opposed to what you're actively involved in, what might really make you rich.
MFMN: Is asset allocation a thing of the past?
Rekenthaler: No. I don't see asset allocation as a thing of the past. I do see the days of magic asset allocation prescriptions as a thing of the past. There have been segments in the financial advisory community that have featured allocation programs that purport to show that an investor needs to be four percent in this asset class and seven percent in this asset class and that if you're off by two percentage points, it all falls apart. Those programs purport to show a degree of accuracy and precision that just is not possible.
A lot of those asset allocation programs tended to put people into fringe asset classes like emerging markets, real estate investment trusts, energy, commodities, et cetera and they performed poorly. That was a fad of the 90s that is over. I don't think you will see these programs making a science out of asset allocation.
But the practice of diversifying between different assets, no, I don't think that's over. It has been wounded a little bit in the late 90s because, in substance, you got richer the more you ignored asset allocation. That was an accident of the times. It won't always be the case.
So I think asset allocation will stay around. It got oversold and the markets were unfriendly to the concept. But it hasn't disappeared nor will it disappear.
MFMN: If investment advice is an art rather than a science, does that present a problem for investment advice online?
Rekenthaler: Investment advice online is capable of no more or no less accuracy than face-to-face investment advice. Both online investment advice and face-to-face investment advice are hampered by the fact that the markets are surrounded with uncertainty. If we knew for certain that stocks would return 11 percent per year over the next 15 years with a specified amount of volatility, investing would be a mathematical exercise.
However, we don't know that. We can make estimates about what will occur in the financial markets but we don't know. So there is an enormous amount of uncertainty that makes any financial planning a complex affair, one that shouldn't be delivered in a way that the user thinks there are guarantees. That problem would occur either with online or in-person advice.
To me, the challenge for online advice is the communication challenge. When you're sitting with someone face to face, there is a lot of information and knowledge that is imparted by expression and non-verbal communication. In addition, it's a lot easier to have a true two-way conversation with a person as opposed to a program. An advisor gets a chance to communicate the notions of uncertainty. There is a tremendous amount of valuable teaching and learning that occurs in these conversations.
Can an online program replace those? I think not. I think an online program can do some of that. As programs get better they will do more of that well. But programs aren't people, and I don't think in my lifetime that we're going to mistake them for people.
MFMN: Are fund expenses too high?
Rekenthaler: I hesitate to call fund expenses too high because that's a bit of a value judgement. I think that just in pure economic terms, fund expenses can go down.
The typical fund company's profit margins still are well above that of the typical U.S. industry, which implies that there's room for people to compete aggressively on price and push the prices down. That's what usually happens. The fund industry has been much more inoculated against price wars that slash the margins of the industry than other industries. Nevertheless, the potential is there whenever you have good margins. The continued interest and success of indexing and emerging investment alternatives all will put pressure on prices. I see very slowly over time average prices paid by investors for funds declining. I see continued pressure, but nothing revolutionary.
MFMN: Are fund directors doing enough on fund expenses? Do you have a point of view on the role of fund directors?
Rekenthaler: My view on fund directors is we have an opportunity to watch the Soviet system at work here at home. If you think about the way that the business of fund directors works and the way the Soviet Union used to operate, there really are quite a number of similarities.
In the Soviet Union, you had to be a party member to really make decisions and have power. With fund directors, effectively it's open to people who work and circulate in the right circles- people who have contacts and are known by executives in the fund industry. It's not exactly every day Americans.
There's no pay for performance in the Soviet system or for fund directors. It's kind of a flat pay scale and one that doesn't change much, regardless of how the fund family does. Both systems are defined by long tenure. And they're secretive as well. It was very hard to know what was going on in the party meetings. And it's hard to know what goes on at fund directors' meetings, which are held behind closed doors. Fund directors are notorious for not exactly courting the press or taking phone calls from or being in communication with shareholders.
My modest proposal has been for fund directors to do what the rest of the world has done and embrace capitalism. Have fund directors compensated in a way that they have very modest pay and probably a fair amount of criticism if the funds that they are associated with don't perform well. On the other hand, if the funds are successful, I would have a very aggressive pay scale.
MFMN: Do you see that as a way to improve directors' accountability.
Rekenthaler: Yes. I think that would focus their attention. You asked about fund expenses. Clearly now directors aren't pushing much on costs because the people who they would push would like the issue not to be raised. And there is no incentive to push on costs. If you push on costs, you get everybody sitting around you irritated. There is a little less likelihood that you're back next year in the job. If you don't push on costs, everybody is happy and you're definitely back next year on the job.
MFMN: You don't think directors are particularly independent from the adviser?
Rekenthaler: No. They're certainly not independent from the adviser. The adviser is who they're in contact with, in communication with. They're brought in by the adviser. They're given information by the adviser in these meetings. Everything they do is adviser oriented.
I don't think people are inherently bad or dishonest or evil. It's just their (the directors') climate. If directors were surrounded by ordinary shareholders and that's what colored their thoughts, they naturally would start to think like shareholders. They sit around fund executives and they think like fund executives.
MFMN: You've taken occasional jabs at the SEC. Is there anything now that the SEC is leaving undone with respect to funds?
Rekenthaler: I've certainly taken jabs at the SEC. However, as I look at the scene right now, I don't have any major quarrels with the work the SEC is doing.
In general, I think the fund industry and the SEC both are to be commended for making sure that the industry is open. I have to say in the 12 years I've been at Morningstar I've been continually surprised and pleased with the level of cooperation that is given to us when we call companies and ask questions. Even before anybody knew who Morningstar was and companies had no real reason to believe that we would ever amount to anything and that our viewpoints would be important to their business, we had a lot of people opening their doors.
I don't want to let my occasional quibbles or disagreements over specific points mar the bigger picture, which is that the fund industry does a good job of being open. It recognizes that it is in the position that it is because it is trusted by the American public. The fund industry recognizes that as part of the contract with the American public that earned the industry its trust, it needs to stay clean and put up with various SEC regulations.
MFMN: You also have differed with the ICI occasionally. Any thoughts on the ICI?
Rekenthaler: The ICI is a pretty good trade organization, pretty reasonable. They're still a trade organization. The SEC is willing to go to the fund industry and tell them things they don't want to hear. The SEC has a very cooperative relationship with the fund industry. It probably isn't going to rock that boat so much that that many people are going to fall in the water. But it's still going to push and make some waves.
As somebody independent of the fund industry and thinking like a fund investor, I prefer the SEC to the ICI. But I recognize that the way the American system works is that industries have trade organizations. I suppose the ICI is a necessary evil as are other lobbying groups. As necessary evils go, they're a pretty good one.
MFMN: Where does Morningstar's growth lie?
Rekenthaler: Morningstar's main growth plans are centered on three areas. The first is international. We plan to be the global retail brand for investment information.
The second thing we're doing is putting energy into Morningstar.com. In the last year, we've spent a lot of money on Morningstar.com, enhancing the content of it as well as publicizing it. Our traffic is about four to five times as high today as it was a year ago.
A third item of growth is related to the issue of advice. Both in expanding our offerings to financial advisors and giving them a web-based solution. Right now Morningstar Principia CD-ROM software is our leading product that we sell to financial advisors. We want to migrate Principia to the web and bring out a lot of other services to help advisors deliver advice. We also are present in online advice ourselves with Morningstar ClearFuture, which is an online advice service for 401k participants.
MFMN: Do you have new products in the pipeline?
Rekenthaler: Clearly with online advice, the 401(k)-only application is just the first of many. We'll be adding ability to deal with taxable accounts and do retirement planning across both tax-sheltered and taxable accounts. We'll also be building a capability to look at retirement planning. Not planning for retirement, but what do you do once you're there; a spending planner.
Advisor.com, what we're going to do for the financial advisors, is pretty neat. I'm just not at liberty to talk about that right now. We haven't quite launched that.
There's a lot going on. We received $91 million last August when Softbank purchased 20 percent of Morningstar. The first three or four months we were hesitant to spend it. We looked at it in a little bit of shock. We were so used to financing ourselves through our company's own internal cash flow. It took a little while to adjust, but believe me, we're adjusted now. We're spending aggressively, hiring aggressively and expanding in several directions.
MFMN: Any plans to rate exchange-traded funds?
Rekenthaler: We are compiling a database on that. We'll have to figure out how to package that. But there is increasing interest in exchange-traded funds and we're going to be part of the discussion.
MFMN: How about rating fund firms?
Rekenthaler: We haven't officially done anything in terms of rating fund firms. We write about the capabilities of different firms. We might run specific articles that say this firm does this better than that firm. But we haven't come up with overall grades and rating for firms. If we do, it will be because we think this information is useful to investors. We're not going to rate fund families and have some kind of business model where we're rating fund families and charging fund families for the ratings.
MFMN: Any thoughts on a Morningstar initial public offering in light of the Softbank investment?
Rekenthaler: There's no plan to somehow make Softbank's investment liquid in the year 2000. And I'd be surprised personally if we do anything this year.
But that's speaking personally rather than as an official company representative on the issue because I'm only peripherally involved with our capital planning. But you're right. Softbank doesn't put 20 percent in a company with the notion that five, 10 years from now it's private. There's no way for them to cash out or even assess the value of that stake.
That investment changed our environment in many ways, one of which was the $91 million that it brought that enabled us to expand more rapidly. But the investment also puts pressure on Morningstar management to find a way of letting Softbank assess the value that's created in the company and potentially take cash out of the company instead of just putting it in. That time frame wasn't a 12-month or 18-month time frame but it's probably not a 10-year time frame either.