02 Jul 2014, Chicago, Illinois, USA --- Bill Gross, co-founder and co-chief investment officer of Pacific Investment Management Company (PIMCO), speaks at the Morningstar Investment Conference in Chicago, Illinois, in this June 19, 2014 file photo. Gross' Pimco Total Return Fund, the world's largest bond fund, posted $4.5 billion in net outflows in June, marking its 14th straight month of investor withdrawals despite improving performance, Morningstar data showed on July 2, 2014. REUTERS/Jim Young/Files (UNITED STATES - Tags: BUSINESS) --- Image by © JIM YOUNG/Reuters/Corbis
Charm offensive: Bill Gross, founder of Pimco, who this spring needed to retain the support of Morningstar

This spring, when the management turmoil at Pimco burst into the open and investors were deserting the bond firm’s flagship fund, Bill Gross knew there was one person he absolutely needed to keep on his side.

Mr Gross, Pimco’s outspoken founder and one of the world’s most recognisable investors, launched a full-scale charm offensive on a little-known fund analyst named Eric Jacobson. Mr Jacobson and his team at Morningstar had the power to strip the Pimco fund of its “gold” rating – a move that could help turn a publicity crisis into a business crisis. Mr Gross, who was taking heat for his sometimes brutal leadership style, repeatedly pleaded his case with Mr Jacobson, eventually securing Morningstar’s enthusiastic endorsement.

A few months later, during a speech at Morningstar’s investment conference in Chicago, he singled out Mr Jacobson for compliments from the stage. “If you really wanted to know about me, just ask Eric Jacobson here at the front table because I’ve told him a hundred times during the past few months exactly what a great guy I am,” Mr Gross said. “Thank you Eric for putting up with me . . . telling you how wonderful Pimco is.”

Such is the influence of Morningstar on the $30tn global mutual fund industry. Morningstar’s ratings have the power to move money, which is why many mutual fund managers have appointed an executive dedicated to handling relations with it.

What began in 1984 as a quarterly booklet providing data on 400 mutual funds, produced by former stock analyst Joe Mansueto from his one-
bedroom apartment in Chicago’s Lincoln Park, has mushroomed into a $3bn company producing research on more than 200,000 funds, slicing and dicing the investment universe and stamping every fund with a “star rating” to reflect its performance history.

Yet a recent spat between Morningstar and one of Mr Gross’s rivals has highlighted the sometimes fraught relationship between the company and the industry it covers, where grumblings about the quality of its work and the solidity of its methodology are commonplace.

For its part, Morningstar openly agonises over how best to make sense of the increasingly bewildering array of funds on offer, and about how to appropriately wield its power on behalf of savers. (Morningstar provides managed funds data to the Financial Times.)

“The investment world is hard-wired to sell investment product, and there are not a lot of people out there looking out for the interests of investors,” Mr Mansueto said in an interview. “We help millions of investors every day to achieve better outcomes.”

Such is the ubiquity of Morningstar’s rating system that investment advisers say it is impossible to get their clients to buy anything that does not have a four or five-star rating, no matter how many times they are warned that the past is no guide to the future. Repeated academic studies have shown that, when the Morningstar algorithm spits out a change to a fund’s performance ranking, money will pour in or out.

“Morningstar is a data and information megahouse,” said Todd Wilhelm, head of mutual fund research at Edward Jones, a US chain of financial advisers. Its power is such that it is able to demand monthly portfolio breakdowns and data on inflows and outflows from mutual fund managers, helping to illuminate quickly how a fund is doing, and why. “Getting that access would be a challenge for others,” Mr Wilhelm said.

Morningstar ranks mutual funds according to two different methodologies, both of them controversial. Its most influential, a one to five-star rating system. It is calculated by ranking a fund’s risk-adjusted performance against a basket of similar funds over three, five and 10 years, taking fees into account. It is a backward-looking measure and critics say it encourages investors to chase past performance instead of thinking about how a fund might perform in the future.

Morningstar

History is strewn with examples where star fund managers have fallen to earth when their luck or skill deserted them, but the Morningstar ranking adjusted only slowly downwards, with Legg Mason’s Bill Miller perhaps being the most prominent example. His 15 consecutive years of beating the market ended abruptly in 2005 and he underperformed for five of the next six years before relinquishing control of his main fund.

To counter concerns about the backward-looking star rating, Morningstar also publishes an “analyst rating” as a potential guide to the future. It takes into account fees, risk management procedures and the strength of the portfolio manager, his or her team and the firm as a whole. On this measure, funds can be rated gold, silver, bronze, neutral or negative.

As it has beefed up these more subjective ratings, industry criticism has increased, though mutual fund executives praise its commitment to educating retail investors. The criticisms tend to stay private.

“It is one step away from talking about your regulator,” said an executive at one of the world’s largest asset managers. “You just don’t do it.”

Morningstar has 97 analysts covering mutual funds, including 42 in the $15tn US market. One bone of contention is that fewer than one quarter are qualified as chartered financial analysts. The company says their average industry experience is 11 years, and almost half have advanced degrees.

“If I had a negative it would be that they have got a big job to do,” said Ron O’Hanley, who until this year was head of Fidelity’s $1.9tn asset management arm. “Given how large asset management has become, their analysts are stretched and, in some cases, they are not going as deep as they should,” he said. “I have been impressed with most of the people we have dealt with but often left with the feeling, ‘I wish you knew us better’.”

The comment is echoed at Eaton Vance, a Boston-based manager with $300bn in assets under management. “Rather than rely solely on Morningstar ratings, we believe that investors should seek professional guidance from a financial adviser, many of whom use Morningstar ratings as one of several inputs for important portfolio decisions,” said Elaine Sullivan, director of retail marketing and the Eaton Vance executive in charge of relations with Morningstar.

DoubleLine, the fast-growing asset management firm set up by bond maven Jeffrey Gundlach, after he was fired from Los Angeles-based manager TCW in 2009, has emerged as Morningstar’s stiffest critic. It alleges Morningstar analysts have a history of bias against the young firm and is refusing to meet analysts because of what it says is their inability to understand fixed income investments.

Morningstar gave DoubleLine’s flagship fund only a neutral analyst rating, and last month it pulled the rating altogether, declaring it “not ratable” without co-operation from the firm. It stands by its claims that DoubleLine funds are riskier than other fixed income vehicles because of Mr Gundlach’s fondness for “esoteric” mortgage-backed securities (MBS).

“If we see complexity plus a willingness to not disclose, to not open up, we feel a need to point out these red flags to investors,” Mr Mansueto said. “This is what got firms into trouble in the financial crisis: people were putting ratings on things they didn’t understand and things came to a bad end.”

The dispute goes back to the fraught beginnings of Mr Gundlach’s firm, said DoubleLine analyst Loren Fleckenstein. “Within hours, if not minutes after Jeffrey was fired, Morningstar.com published a report publicly approving the termination and wrongly predicting TCW likely would keep most of the key people on the TCW MBS team – without bothering to contact Jeffrey or Phil [Barach, his investment partner] for their input.”

DoubleLine says this is an example of Morningstar being too close to the fund management firms, such as TCW, whose funds it rates and on whose data it relies. Asset managers are also among Morningstar’s biggest clients for its databases and software.

Mike Lipper, who sold his rival mutual fund ranking business to Thomson Reuters and is now an investment consultant, says closeness is a risk. “If a majority of the big players have a view on things, that may have some influence not on what you think, but on how you think.”

Morningstar has a code of ethics that forbids analysts from speaking to anyone from the commercial operations. “We never pull any punches, we say the good and the bad, and say when we see issues that are detrimental to investors,” Mr Mansueto said. “The culture is very deeply rooted, and this is what enables me to sleep very well at night.”

Mr Mansueto owns 55 per cent of the firm, and Morningstar takes a quirky approach to dealing with its outside shareholders. Instead of conducting the typical quarterly conference call with Wall Street, the company instead takes written questions from investors and posts a selection of answers monthly on its website.

The company is branching out into potentially lucrative areas, which include investing directly for customers. Mr Mansueto is building a pensions business that can create a customised portfolio around a target retirement date, and it advises on the construction of “funds of funds” and multi-asset portfolios, which are increasingly in favour in the investment industry.

Morningstar’s new investment businesses, currently accounting for only 20 per cent of revenue, could bring it into competition with the fund managers it rates. Niamh Alexander, analyst at brokerage firm KBW, says this could limit its growth potential. “If your biggest customers are fund managers, you are not also going to want to be one of the biggest fund managers,” she said.

Mr Mansueto said the firm would never rate its own products.

One other area of difficulty for Morningstar is keeping up with the proliferating types of funds, especially ones that mingle different classes of assets or those that give portfolio managers wide discretion to invest as they see fit.

These trends, if they broaden, threaten to wreak havoc on Morningstar’s traditional way of dividing funds into categories based on what they invest in, such as long-term bonds or growth stocks. The number of US mutual fund categories has grown to 105, but some, such as the increasingly popular “non-traditional bond fund” category, remain a mish-mash of funds that do not fit elsewhere.

Even within the most stable categories, such as intermediate-term bond funds, portfolio managers complain apples and oranges are being ranked against each other. One of Pimco’s grumbles is that its flagship Total Return Bond fund fell down the rankings last year because, unlike many in the category, its prospectus forbids it from investing more than 10 per cent of the portfolio in junk bonds. It was not a gripe that Mr Gross addressed on stage in Chicago.

After all, Morningstar is a force that has to be dealt with, like it or not. And as Mr Lipper said: “No one ever likes to be measured – unless you are winning.”

Rivals: More room to run with professional advisers

When S&P Capital IQ was rolling out a new mutual fund ranking system, it planned on using equity research-style “overweight” and “underweight” recommendations, but every financial adviser they pitched it to came back with the same message.

“They said: ‘My clients will only buy a five-star fund’,” recalls Todd Rosenbluth, the S&P Capital IQ director who created the system. “I said that it was a different kind of methodology, and they replied, ‘Yes, but my clients are only going to buy a five-star fund.’”

Morningstar and its star rating has what Mr Rosenbluth calls a “chokehold” over retail investors. So S&P instead targets financial advisers who have discretion over their clients’ money.

Other Morningstar rivals have found space for their rankings and advice, pushing the firm into third place among data providers to advisers, according to Great Lakes Review.

Lipper, the 41-year-old research group acquired by Thomson Reuters in 1998, has deeper roots with the financial adviser community. It touts mutual fund rankings that give professional users more detail on which factors contribute to the overall score. Bloomberg is the dominant provider of fund data to advisers.

Institutional investors traditionally rely on consultants such as Mercer or Wilshire Associates, who have their own private lists of recommended mutual funds. Morningstar’s push into the creation of funds of funds and pension advice – assets under management or advisement were $169bn at the end of June – means it is jostling with these professionals more and more.

All these rivals claim to have found a better way to slice and dice the mutual fund universe. S&P Capital IQ’s pitch is that it combines backward-looking performance data with forward-looking measures that include analysis of stocks and bonds in the fund.

Mr Rosenbluth thinks it is a better mousetrap, but he capitulated on one point. “We said, OK, you win, we’ll call it a star.”

This story has been updated to correct the number of US mutual fund categories Morningstar follows and to correct the amount of assets it has under management or advisement in the year to June 30. The restrictions on Pimco’s Total Return fund’s ability to invest in junk bonds has also been corrected.

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