by Maggie Mahar
MORNINGSTAR’S STARS
By 1996, individual investors could choose among more than 6,000 funds. The variety was dizzying, the raw performance numbers confusing. To help investors make choices, Morningstar and Lipper Analytical Services ranked the funds.
Predictably, the mutual fund industry seized upon the rankings, turning them into marketing tools. Morningstar’s stars seemed particularly well suited to tub-thumping. “The genius of Morningstar was the stars; it was a wonderful graphic,” said Lipper. “And there was enough mystery behind it that people took it as a judgment call.”7 Lipper’s rankings also figured in many a mutual fund ad, but the stars had a special appeal. They suggested that the mutual fund rating service was handing out grades: five stars equaled an “A,” four stars a “B,” three stars a “C.”
That was not Morningstar’s intention. The company insisted that the stars were not buy and sell recommendations. “The stars are just a starting point,” said Morningstar’s Don Phillips. “If a fund receives five stars for ten years of performance, you next want to check to see how long the current manager has been running the fund. If he started just last year, the stars reflect someone else’s performance.”
Morningstar’s critics suggested that when a new manager came on board, the slate should be wiped clean. The rating service should wait and see how the new manager performed before awarding stars. But in the nineties, fund managers came and went with such regularity that if Morningstar waited until a manager had even two years’ experience under his belt, the rating system would cover fewer funds. A huge number of five-and ten-year rankings would have disappeared altogether: managers seldom stayed with a fund that long. So when a new manager took charge, Morningstar let the fund keep its stars, leaving it to the investor reading Morningstar’s report to click on “fees and management” in order to discover that the stars said nothing about the current manager’s talent. Once again, the burden was on the individual investor.
“Before making a decision, an investor also should look at the fund’s year-by-year returns,” Phillips added. After all, a five-star fund’s performance could turn on just one or two outstanding years—something that an investor would see only if he went beyond the first page of the online report to look at the year-by-year breakdown of the fund’s total returns. “That is what I look at. I want to see consistent returns,” says Phillips. “But,” he acknowledged, “people do gravitate to shortcuts.” In other words, they count the stars.8
The mutual fund industry also counted the stars—and, in many cases, paid its managers accordingly. “The rankings became far too important,” confided a manager at one large Wall Street brokerage. “Our organization, and many organizations, managed their managers, and compensated their managers, for being in a certain place in the Morningstar or the Lipper pecking order, rather than on their absolute performance. If you made 15 percent—but other funds in your category were willing to take greater risks and made 20 percent—you might earn four stars that year instead of five. As a result, your bonus would shrink—even though your investors had made 15 percent. On the other hand, if you lost 10 percent—but other funds in your category lost 20 percent—you might well pick up a star, and get a raise. Your Morningstar rating could determine your entire bonus.”
Perhaps inevitably, money managers began to let the ratings shape their investment decisions. “Once a week we would get a memo from our boss about how our fund’s ranking stacked up against the weekly Lipper rankings,” he continued. “Sometimes, you made stupid investment decisions—buying a stock that was hot—just to raise your short-term rating. And I did this,” he added ruefully, “even though I had all of my own savings in my own fund.”9
Meanwhile, the marketers learned how to tool the stars to fit their ads, boasting, for example: “42 of our 66 rated funds received an Overall Morningstar Rating of four or five stars.” The ad was worded carefully: “of our rated funds” was the key phrase. Typically, not all of a company’s funds were rated.
“Often a fund would use its own money to start four ‘incubator funds,’” Mark Headley, president of Matthews Asian Funds, explained. “If one of the four flourished, the firm would quietly close the other three. The one that survived would be rated. Investors saw only the survivors.”10
Even after a fund was established, if it flopped, it could be discreetly buried. Often a lemon was merged into another, larger and more successful fund that could “absorb” the losses. “They ended up merging my fund into our global fund,” recalled the manager of a failed sector fund. “This took some time. You had to have a shareholder vote—send everyone a proxy. Most people, when they get a proxy, it goes right in the garbage can. It wasn’t that people didn’t want to merge—they were just apathetic. At the same time, the brokers at our firm who had put the clients into the fund in the first place weren’t too enthusiastic about calling their clients and saying, ‘You know that fund I recommended—well, we need to deep-six it, so if you could just fill out that proxy…’ The whole process took about a year,” he recalled.11
While investors in the so-called vanishing fund may have felt that they had been rescued from a desert island, “the fact remains that they end up with a fund and manager they didn’t choose—the equivalent of buying a Ford and finding a Chevy in the driveway one day,” pointed out The Wall Street Journal ’s Ian McDonald. As for investors who owned the larger, more successful fund, when they finally inherited the loser, tax law forced their manager to hold on to one-third of that fund’s positions for at least one year.12 The only clear winners in the process: the marketers, who emerged with a cleaner record for their ads.
THE COST OF MARKETING
As the mutual fund industry grew, so did the cost of promoting its funds. Who footed the bill? Mutual fund investors. “12b-1” fees were created specifically so that existing investors could underwrite the expense of bringing in new investors. Incredibly, even when a fund was closed to new customers, Morningstar reported that as many as one-fourth of those closed funds continued charging 12b-1 fees.
Some financial publications tiptoed around their mutual fund advertisers. To its great credit, Smart Money asked the obvious but no doubt unwelcome question: “How do these closed funds justify charging a marketing fee?
“‘We’re not interested in talking about that,’ [replied] Mainstay Funds’ spokeswoman Diane Kagel. William Shiebler, senior managing director at Putnam Investments, which had several closed funds that charged 12b-1 fees, was more expansive: ‘They’re paid to the brokers so that they have a continuing interest in the fund,’ he explained.
“In other words,” Smart Money concluded, “the mutual fund companies are using shareholders’ money to pay off brokers who sold the funds (and thus earned a healthy commission) in order to keep them from moving their clients’ money elsewhere.”13
An investor might well assume that most of his 12b-1 fees pay for glossy magazine ads. In fact, the lion’s share of the money that mutual fund companies spend on marketing is funneled to brokers and financial planners. “Only a small portion of the fund business advertises. Most marketing has to do with relationships through the broker distribution system, and to a lesser degree the financial planners,” Michael Lipper explained. “Some financial planners take fees only from their clients. But they are the minority, because they can’t live on fees unless they have extremely wealthy clients with huge accounts.” Do most individual investors realize that their financial planner may receive a fee for recommending a particular fund? “They’ve been told,” said Lipper. “But I don’t know if they know.”14
Certainly, few investors realized that the mutual fund industry paid brokerages such as Merrill Lynch and Citgroup’s Salomon Smith Barney to move their merchandise. In what is euphemistically called “revenue sharing,” mutual fund companies such as Franklin Resources, Putnam Investments, and AIM Management Group were shelling out princely sums to the brokerages—above and beyond the commissions paid to brokers when they sold a fund. These are f
ees that the fund companies pay directly to the brokerage itself, in return for special access to the firm’s brokers.
By the end of the decade, fund companies were forking over as much as $2 billion (in what a cynic might call kickbacks) according to Institutional Investor, citing estimates by Boston-based Financial Research Corp., a strategic consulting firm. By comparison, FRC reckoned that mutual fund companies spent just $515 million on advertising. From 1996 through 2001, FRC estimated that the cost of “revenue sharing” had doubled.
By paying off the brokerages, fund companies could gain a place on a short, confidential list of “preferred” fund providers that most brokerages maintain. The investor who buys the fund almost never knows about the list. Sometimes even his broker is unaware of the fund’s special standing, though he might well figure it out. For a preferred provider is more than a salesman with a foot in the door—he enjoys easy access to a firm’s brokers.15 That access gives him the opportunity to wine and dine a broker even after he has sold a fund. This is what Putnam’s Shiebler meant when he explained that mutual fund companies paid 12b-1 fees to brokerages “so that they have a continuing interest in the fund.” After all, if the payments did not continue, the firm’s brokers might decide to switch their clients to another fund.
FINDING A HOME FOR THE MONEY
In the eyes of some equity fund managers, the marketers succeeded all too well. In 1996, a record $208 billion flooded into stock funds—up more than 60 percent from the previous record of $129.6 billion in 1993, the year when investors began to shift, in large numbers, from fixed income and money market funds, into equities.16
Now portfolio managers had to contend with the avalanche of money landing at their doors. “Dozens of portfolio managers would tell me that when they opened the mail in the morning, there would be another $100 million,” said George Kelly, a technology analyst at Morgan Stanley. “Meanwhile, their bylaws often mandated that they stay fully invested. They had to buy stocks. And there was some urgency—there might be another $100 million in the afternoon mail.” Under the gun, “they usually bought stocks that they knew, stocks that they already owned,” Kelly explained. “Generally that meant they bought large-cap, highly liquid stocks.” And so the new Nifty Fifty was canonized.17
As retirement dollars poured into stock funds, managers did their best to put the money to work as quickly as possible, and by and large, they succeeded. In 1996, the average equity fund held only 6.2 percent of its assets in “cash or its equivalent” (safe, short-term instruments such as Treasury bills)—down from almost 13 percent in 1990. This meant that if the market turned sour, and investors suddenly decided to cash in their chips, fund managers would be forced to sell stocks—even though prices were falling—just as Fidelity Magellan’s Peter Lynch had been forced to sell during the October ’87 crash. In the past, fund managers had kept a cash cushion to try to avoid such forced sales, but as the bull market heated up, the cushion shrank. By March of 2000, the average equity fund held just 4 percent of its assets in cash. Even during the bear market that followed, fund managers remained close to fully invested: at the end of 2002, the average equity fund held less than 6 percent cash.18 (See chart “Equity Mutual Fund Cash Ratio” on page 461 of the Appendix.)
Yet even while portfolio managers struggled to find a home for their investors’ money, more than a few began moving their personal nest eggs into bonds and cash. Robert Marcin, manager of the $2.3 billion MAS Funds Value Portfolio, was candid. In December of 1996, he told The Wall Street Journal that he had cut back on the stock holdings in his personal portfolio, even while keeping his clients’ money fully invested. In fact, Marcin confided, he was “bending” his usual investment rules to pump up the mutual fund’s stock holding. “He is slower to sell issues that have risen sharply, and hurries to invest new money,” Wall Street’s paper of record reported. After all, “investors expect funds to stay fully invested,” said Marcin.19
Meanwhile, out-of-breath fund managers still struggled to keep up with the Dow and the S&P. As the benchmark indices levitated, a manager’s only hope was to invest his clients’ money in the index leaders—in other words, the market’s most expensive stocks. The investment risk inherent in buying the highfliers was evident. But in a runaway bull market fund managers had to worry about another type of risk: career risk. If they could not match the index, they could forget about fat bonuses. Indeed, in some cases, they could forget about their jobs.
“Even the administrators in charge of corporate 401(k) plans were telling you how to invest,” groused a manager who ran a fairly conservative growth fund. “You might be making 11 percent—but they would say, ‘Look at Janus, they’re making 22 percent. Why can’t you do that?’ If your returns didn’t equal those of the high-growth funds, they would drop you from their plan. They wanted all jazz, all the time. The system was stacked in favor of fund managers who took the greatest risks—at least until they blew up.”20
With higher rewards comes higher risk. A portfolio manager who chased returns of 20 percent or more faced a greater chance of blowing up. But if he took a more cautious course, he could scuttle his own career. Laurence Siegel, director of investment policy research at the Ford Foundation, spelled out the dilemma in an interview with Kathryn Welling, editor of welling@weeden:
A money manager is judged by his results, and those results break down into four categories, Siegel explained. “You can be right and with the crowd—which is fine…. You can be right and alone—and then you are a hero. You can be wrong and with the crowd, which isn’t actually so bad. When everyone else is down it doesn’t hurt [the fund manager’s career] to be down. Or you can be wrong and alone and then you really look like an idiot.” This is the ignominious fate that a career-conscious fund manager strives to avoid at all costs.
When younger fund managers, “under the age of say, 45 or 50,” make investment decisions, “job-protecting behavior…dominates,” Siegel observed—a fact of life he described as “understandable, even if it is not good for the client. This is called the principal-agent conflict,” Siegel added, summing up the relationship between investors and portfolio managers. “Preserving purchasing power and earning a return on capital is good for the client. Minimizing the risk of being wrong and alone is good for the managers.”21
In other words, it is in the fund manager’s interest to follow the herd—even if he thinks the herd is wrong. In the worst-case scenario, he will go down in flames along with everyone else. No one will blame him. Alternatively, if he dares to think outside of the box, and do what he believes is in the best long-term interest of his clients, he takes the chance of being “wrong and alone.” Not surprisingly, as the market climbed, most managers chose investment risk (for their clients) over career risk (for themselves).
In 1996, a portfolio manger who had any doubts about which course to take need only glance over his shoulder to glimpse the ghost of Jeff Vinik. The image of Vinik, Fidelity Magellan’s former manager, would be sufficient to remind him that in a market driven by momentum, his position was only as secure as that quarter’s returns.
“FORGET JEFF VINIK”
When Jeff Vinik took the helm of Fidelity’s flagship fund, Fidelity Magellan, in the summer of 1992, he shocked some investors by dumping the then-popular consumer stocks that Magellan’s founder, Peter Lynch, had favored, replacing them with stocks in less popular sectors: energy, technology, and heavy industry. To some, it seemed a reckless and irreverent move.
A year later, Barron’s declared Vinik a “winner.” As he had predicted, semiconductor, oil-service, and natural-gas shares were leading the market, “while the favorites of yesteryear, the peddlers of brand-name goods,” were down by about 10 percent.
“Jeff will buy what he wants to buy,” John Rekenthaler, editor of Morningstar Reports, said at the time. “He’s never had a taste for growth stocks. He likes buying stocks with below-market multiples,” he added, referring to Vinik’s preference for what he called
GARP—“growth at a reasonable price.” Even at the end of the decade, Vinik avoided the price/earnings ratios of 30, 40, or 50 that had become commonplace in the large-cap universe. “For a company that’s growing 15% or 20%, [I might pay] 12 times earnings,” he confided. “For a company that’s growing 40%, it might be 25 times earnings.”
In 1993, Barron’s noted, “Vinik’s distaste for traditional growth stocks is ironic considering that Magellan is supposed to be a growth-stock fund. But,” the magazine acknowledged, “it’s hard to argue with his results.”22
For the moment, Vinik was allowed his head. At the time, Fidelity’s stars were given a fairly free rein to invest as they saw fit. In the early nineties, for example, when Vinik was steering Fidelity’s Growth and Income Fund, he had tucked 40 percent of its assets into cash, saving investors from the worst effects of the recession. But when Vinik managed the Growth and Income Fund, he was not in the media spotlight. Fidelity Magellan, by contrast, was the world’s largest fund, and the financial press kept him in its sights.23
All went well until the fall of 1995. That was when the 37-year-old portfolio manager began to slash Magellan’s technology holdings. In October, 43 percent of the fund’s assets were committed to technology stocks; by the end of November, Vinik had cut the $53 billion fund’s position to less than 25 percent. Vinik thought the technology sector had become too speculative, and he continued to pare his holdings: by the spring of 1996, a mere 3.5 percent of Magellan’s assets were committed to tech. In the fund’s annual report, Vinik explained that he thought bonds would outperform stocks “over the next year or two.” With that in mind, he put 11 percent of Magellan’s funds into cash, and 19 percent into bonds, mainly long-term Treasuries.24
In one stroke, Vinik had violated the three articles of blind faith that drove the bull market:
