Morningstar Managing Director Don Phillips has been a visible industry figure since the scandal broke, calling for investors to avoid certain shops entangled in the scandal as well as urging the industry to adopt several reforms. MME Associate Editor Chris Frankie sat down with Phillips just before the Morningstar Investment Conference to get his views on the ICI's new president, Congress and investors.

MME: Paul Schott Stevens is the new ICI president. Do you expect anything different from him and his tenure than from that of Matt Fink?

Phillips: I'm guardedly optimistic about Paul Stevens. He is a smart guy, and I think he was the right choice. He knows the territory. Matt Fink was a smart guy and knew the territory, too, but Matt just got so ingrained or so defensive that I don't think he was doing his job particularly well in the later years.

I've talked to several journalists over the last three or four months who have relayed stories of Matt Fink slamming down the phone because he got so angry at their questions. If you are the chief lobbyist for the fund industry, you should be able to handle a tough call from a reporter, and Matt at the end wasn't able to do that.

I think that Matt had gotten the industry to a point where the press and the public didn't trust the industry. I think he got very focused on defending the short-term desires of the fund industry rather than raising the debate to focus everyone on the long term. In the long term, fund companies win if and only if investors win.

Matt got bogged down in some of the minutia--things like the industry's opposition to proxy votes. That was just so wrongheaded, and in the wake of the Enron and WorldCom scandals, for the industry to pick that point to fight against was absurd. It took an industry, which up to that point had been considered pretty clean, and all of a sudden put it right front and center in front of the public saying, We've got something we prefer to hide from investors.' It was just the absolute wrong time to take that stance.

And what's more, the ICI overplayed its hand, insisting all these terrible things would happen if funds were forced to disclose how they voted their proxies. They sent big huge things of paper the size of two phone books out to all of these different journalists, saying, Here's all the paperwork we'd have to file.' They talked about picketers who'd be protesting Fidelity at 82 Devonshire and they painted this doomsday scenario of how funds would be completely inundated with all this extra work and hassles. The things that the industry said would happen didn't happen. So, it's just one more thing that undermined the ICI's credibility and the industry's credibility.

I just don't think it would take that much to improve the industry's relationship with the press and the public. Mutual funds have a good story to tell. This is a vehicle that has empowered a lot of people to meet their financial goals. I don't think it takes an extraordinarily skilled person to tell that. But the industry had gotten to a point where it had become very ineffective at telling that story. I think Paul Stevens will be able to improve upon that dramatically. At the end of the day, funds are a terrific vehicle for investors, but if you pretend they are perfect, you set yourself up for the fall the industry has experienced the last year and a half.

MME: The Baker Bill passed in the House, and there are numerous proposals in the Senate. While the SEC is currently handling industry reforms, does the mutual fund industry need Congress to be involved?

Phillips: I'm not sure that it does. I think the threat of Congressional involvement is an awfully powerful force in and of itself. My gut tells me that the fund industry dodged a bullet here. I think if all of this had happened 12 months earlier and you had all of these stories of serious abuses coming out during a bear market, you would have seen asset flows in the fund industry dry up. In fact, I think you would have seen negative flows. I think that would have lit a fire under a lot of Congressmen.

It could have been a very convenient issue for Congressmen to rally around. But since all of this happened in the wake of terrific investment returns as we saw in calendar 2003, the asset flows were positive, so no one could make the case that Americans have given up on mutual funds.

But I hope that the industry takes away the lesson that some change would be a good thing. You are already seeing some firms take positive steps. Look at what Bob Pozen has done at MFS by getting rid of soft dollars and looking more into breaking the cartel the big wirehouses have on fixed prices for execution. I think it's a real positive that there's more time to come up with these types of solutions as opposed to trying to do it on Congress' time schedule.

Also, you're not going to see the same old SEC. The agency is going to be under a lot of pressure to prove that they're up to the task and they're going to be pretty tough. The industry has to approach the SEC with a sense of humility and a willingness to compromise.

MME: There has been a lot of debate about all the different reform proposals from regulators, the industry and even Congress. However, the average investor doesn't understand all the information in the way it is presented to them. Do you think the investor will be any better off when all is said and done?

Phillips: Yes, I do. One thing to keep in mind is that the average fund investor is going through an intermediary. There are very few people who buy funds directly from fund companies. The reality is that a lot of financial advisers who sell funds are much more willing to do due diligence on funds. They want more disclosure, and they're capable of extracting good information from the kind of additional disclosure that's being talked about.

The other major thing for the fund industry is that it has to position itself in the public's mind and with the financial press as an industry that is on the side of investors and that is willing to accept a higher standard. When the fund industry starts whining that it is held to a higher standard than hedge funds, which it often does, it comes off looking bad. The playing field is so tilted towards mutual funds with things like 401(k) plans, 529 plans and IRAs, all of which naturally encourage more participation in mutual funds. None of those things skew assets towards the hedge fund industry. With that greater public role that funds play comes a higher level of responsibility, and it is important that the industry stops fighting against those calls and perhaps sits down and considers which of the proposals might have merit.

MME: What about the provisions for the boards?

Phillips: I think the industry is fighting a dumb fight there because it makes one ask the question: Why are you so opposed to having an independent board? Why would that be such an inconvenience? It seems like something that engages board members and creates a checks and balances on how money is being managed in mutual funds would be a real positive. I recognize there may be some inconveniences for some groups, but I think the greater good is making sure the checks and balances are in place, and they work as well as possible.

MME: Class-action suits may prolong the scandal in the public eye. Putnam admitted guilt when settling with Massachusetts, and Dick Strong offered an apology during Strong's settlement. Do you think that the admissions will come back to bite these firms in lawsuits, and will the potential fallout affect Morningstar's recommendations on the fund shops?

Phillips: One of the sad realities is that the fund industry is always subject to these nuisance suits, these class-action suits that are just too prevalent in American society. I actually have a lot of sympathy for what a lot of the fund companies are up against now. It is one of the unfortunate, if necessary, aspects of doing business in America these days.

It's unfortunate if the threat of these suits keeps what needs to be said from being said. Dick Strong should say he is sorry. Putnam should say they were guilty. What Dick Strong did was wrong. What Larry Lasser did at Putnam was wrong. If you hide behind the legalese of the traditional SEC settlement, neither admitting nor denying guilt, it just keeps what should be said from being said. But it probably does introduce greater legal liability, which is unfortunate.

MME: Does Morningstar take these things into account when making its recommendations?

Phillips: What's most important to us is what fund companies are doing to establish the checks and balances. If they got into trouble, how are they addressing that? The class-action suits are just lawyers looking for money. It is not something that is going to call for greater governance at the fund companies, which is the issue that's of more concern to us.

MME: What do you think is the most important thing attendees should take away from the conference?

Phillips: I think getting back to talking about the investment side of mutual funds, as opposed to the operational side, which has been the focus the last year. There are some very interesting questions to ask: Where do you go from here? For one thing, the industry and most advisers who have been using mutual funds, have been riding this tremendous wave of declining interest rates for more than two decades. What do you do in an environment where interest rates are rising and how do you make sure investors don't get hurt during that time period? It makes for some very interesting questions, such as how do you deal with a market less favorable to financial assets? And the fund industry does not have a particularly good history of encouraging good use out of hard assets or alternative investment strategies, which many investors are looking at more to be a part of their portfolios in the coming years.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.