Introduction

Patrick: [00:01:21] My guest today is Jeff Ptak. Jeff is the head of global manager research at Morningstar. This puts him in a unique position to discuss the state of active management because he gets to see mutual funds from both the bottom-up, through deep diligence on investment strategies and firms, and top-down using Morningstar's data to assess industry-wide trends. Jeff is one of my favorite myth-busters, so be sure to check out a few of the articles he's written linked in the show notes, which can be found at investorfieldguide.com/ptak, which is P-T-A-K. When we spent most of our time discussing different variables for assessing active managers and mutual funds, we also covered his favorite punk rock bands. Please enjoy our conversation. Okay, Jeff, thank you very, very much for doing this with me today. I've always been envious of people in seats like yours, where you have this interesting top-down and bottom-up view of the asset management business, mutual funds, ETFs. And so, maybe where we could start that would be interesting would be to hear, what trends in broadly speaking in the mutual fund and ETF space have your attention and interest today?

Jeff: [00:02:29] Yeah, so first off, thanks Patrick for having me. It's a great pleasure to be able to join you and share our perspective. I would say that certainly the most prevalent trend that we're seeing right now, and this will be familiar I think to a number of your listeners is, the shift towards the lower cost mediums for investment, most notably passive and specifically ETFs. And so, it seems the tide is going out on active, and the money is moving into passive low-cost investments. We've seen a pretty significant shift in market share, just focusing on the US from active I should say, into passive. That is from higher-cost investments into lower-cost investments, and so certainly that's something that we're focusing on. But in a sense that, that's a bit of a result of other forces that have swept the industry, the opening up of platforms, the un-bundling delivery of advice and investment solutions. I think that that's probably spurred the focus on cost among other things and that's one of the reasons why investors and those that are representing them have moved towards passive investments. So, if there's one thing that's probably the biggest one, that's got our attention.

Patrick: [00:03:47] Can we parse that a little bit more, because everyone obviously is living and feeling the move that I would categorize above all else as high cost to low cost. Obviously, that plays itself out a lot of inflows into passive. But I'm curious if there are specific pockets, thinking in the Morningstar Style Box, or different asset classes where you've seen the most flight out of let's say active and or high cost and into passive. And if there are areas where you see less of it, where people seem to continue to believe in active management at least more than other parts of the market.

Jeff: [00:04:24] Yeah, that's an excellent question. I would say that, by far the biggest victim if you want to call it that, or casualty has been large-cap and large-cap growth specifically. We've seen a very big shift of assets from those styles and I'm speaking of US equity styles, large-cap, and large-cap growth that shifted into passive and moats. A lot of that money has ended up in say total stock market Vanguard or a shit load skull in S&P 500 trackers. That's an example where we've seen a real meaningful shift. I would say an area that's been a bit less vulnerable to the shift, areas that are a bit less liquid, a bit less indexable if you will. Good examples would be maybe fixed income in particular munis. It's a harder area to index and it's not quite as liquid as you know. We haven't seen the same sort of wholesale shift there as we have in other areas.

Patrick: [00:05:28] It seems obvious that the trendline towards low cost is secular and not something that will stop or reverse or ebb and flow, but certainly there will be periods of active being more popular. That would probably be exacerbated if the cost and the management fees and taxes, et cetera, and after-tax costs of active solutions come lower and lower. What sort of catalysts do you think we might see to inspire one of those kinds of rallies if you will, bear market rally of sorts inflows to more active management?

Jeff: [00:06:04] Yeah, so that's a great question. There are probably three cyclical factors that have been holding active funds back in particular, especially here in the US and I'm speaking of equity funds. The first is the nature of style leadership. The second is, let's call it a market trend, so up versus down and then the third, which is probably the most technical in nature is dispersion. I'll try to take those sort of briefly one by one. Style leadership, generally speaking as an active manager, it's not in your favor when your subject styles, let's say I'm a large growth manager when my style is leading the way. Why is that? It's because the index to which I'm compared tends to be more style pure than I am and therefore, it's going to outperform if that style is indeed outperforming. That has been the case for the simple reason that, large-cap until relatively recently has been beating small-cap, and also growth has been beating value. Large-cap managers, generally speaking, are messy towards mid and small and towards value, assuming that they're clustering towards their upper right-hand corner of the style box so that's style leadership. Now, the trend is probably the most straightforward. Generally speaking, we find that success rates for active are a bit higher in down markets than they are in up markets. Now, I think there's a bit of a fallacy that holds that active managers will save you during a bear market, it's the reason to invest in active. I would probably be quick to disabuse investors of that, we can touch on that later. We've been in a prolonged bull market that doesn't help active investors. Then the third thing that I mentioned, which is probably the most technical of all is dispersion. Let's just focus on a style. Styles, the returns to styles have been fairly tightly bunched. There hasn't been this big spread between them, and so what that means is that, if you're messy as an active manager or a different type of style, the payoff to you hasn't been as great as perhaps it's been in the past. If those three things reverse, style leadership, the nature of it changes, if we had a pullback in markets, a bear market even and if we saw a bigger dispersion between styles, I think those things are going to help active managers and so that's not going to reverse things. It's not even necessarily going to arrest the shift towards passive, but it could slow it a bit and give active managers maybe their day in the sun again.

Evaluating Fund Managers

Patrick: [00:08:39] You published a really interesting study looking at a group of funds starting in 2006 I believe, and then looking forward 10 years. What you found was that just about 20% of surviving funds outperformed their reference benchmark. But only 8% of those same funds outperformed if you did it on a dollar-weighted basis. If you took investor timing decisions, which tend to be terrible into account, that number is just about one in 12. This makes me think of the Dumb and Dumber Lloyd scene, where he says, "So you're telling me there's a chance," even though it's infinitesimally small.

Jeff: [00:09:15] Right.

Patrick: [00:09:16] With that number in mind, which is a tough number for those out there trying to pick funds ahead of time, trying to position themselves in active funds. Maybe not only that have done well in the past and have good managers, but can stand to do well perspectively. I still want to touch on what your research suggests are important things to look at when evaluating an active manager. Maybe we could go through a list starting with quantitative measures, and then maybe getting into the process and more qualitative measures of how you and your team evaluate fund managers. If you had to list say three to five things that seem to matter for whether or not an active solution makes sense, what would those be?

Jeff: [00:10:03] Yeah, so that's a great question. I think at the top of my list I would put fees. I know what somewhat unoriginal pedestrian answer that is given the shift towards low costs, but it is indeed very, very important. We can get into why that is but generally speaking, our research has found that the cheapest quintile of funds in a given category are about three times as likely to survive and succeed than the most expensive quintile of funds. That's the payoff that you get from choosing cheap, active funds. I think the second thing that I would focus on is, manager ownership of fund shares, as well as manager tenure. Now manager experience is not a panacea. We see plenty of experienced managers that have ho-hum results, aren't all that talented, so that in and of itself isn't a silver bullet. It can be reinforcing though when you see a manager who, not only has been around for a while and applying his or her trade but also eats his or her own cooking. I think that's a pretty defining gesture. It suggests that they really believe in what they're doing, so that's the second thing that I would look for. A third thing that I would look for is, and this is a bit more technical than some people would think, maybe it's obtuse. I do tend to focus on equity managers on the turnover rate. This will depend a bit on the style, but with fundamental managers that have low turnover rates, that tends to tell me quite a bit about how they're wired, how their process works before I even understand how they invest, so I focus on that as the third thing. Then maybe a fourth thing that I'll just throw in as an overarching measure, I want to know something about the fund family concerned. Is it a monoline? Do they only focus on asset management? Or do they hail from a diversified financial services firm that has a lot of different irons in the fire? In which case, the asset management division falls underneath some big tent with all the attendant risks and concerns. Either model can work, but I would say that there's probably a bit more complexity and challenges involved with the second model. Those are four things that I would probably focus on in getting started and looking at a particular, actively managed strategy let's say.

Patrick: [00:12:21] Let's go a little bit deeper on a few of those so starting with ownership, I've read studies certainly that, a majority or an alarming number of active managers either don't have money in their own funds, or the amount is relatively small. Are there some numbers or some kind of general sense that you could give us for what levels you look for, how common it is for managers to have large investments in their own funds?

Jeff: [00:12:48] Sure thing. We will follow what's reported in the public filings and the top rung that's disclosed and I'm going from memory here, is I believe a million or more that's invested in a given fund. Into us, that's the sense the strongest signal. We want to see managers that they're making that sort of gesture, sort of statement of confidence in their strategy. How many managers do this? While I can get you specific numbers, it's a clear minority of managers, of funds that have managers that are investing at that level. We're talking well below 50% of managers, of funds have a manager that is invested at that level. Why don't we see it more often? I would say there's a number of businesses and other more humdrum reasons why we don't see it. In some cases, the manager maybe is running a pot of money in a separately managed account in which perhaps they have an investment. In other cases, perhaps there are jurisdictions where they invest the money, but they don't invest it in the jurisdiction in which it's being offered to you. Then in other cases, they don't care enough to invest their money in it. Maybe the fees are too high. Maybe there's another strategy that they run in-house that they believe more in. In many cases, it boils down unfortunately to that, and so that's why we think it's important for managers to have some skin in the game to show it.

Patrick: [00:14:15] What about the firms behind the asset management firm itself, is there a preference for say boutique or manager owned firms relative to funds that are offered by much bigger fund families or much bigger asset managers?

Jeff: [00:14:28] We're agnostic, so what you would find if you went through our ratings is that we hardly recommend funds from very large diverse firms. We just as hardly recommend funds from boutiques. There are different models, each one has its own set of challenges that attend to it. For instance, with a boutique, it's more difficult to attain scale, generational transfer, depth, breadth, continuity of a team. It can be issues that you want to focus on a bit more intently than you would perhaps in a larger, deeper, broader, more resourced firm. With those larger firms, we talked about it earlier, there's the risk of distraction. There isn't a single-mindedness perhaps that you would have in a boutique model. Perhaps the manager doesn't feel the same direct connection with the strategy he or she is managing, that they would in a boutique setting. And so, I would say that's the diligence that you're going to have to perform and each of those cases is different.

Patrick: [00:15:30] What about that idea of tenure? It seems to me just intuitively that there would be some sort of sweet spot that, too long a tenure would probably mean that the person is closer to retirement. The skill that they brought to bear may not be around for the investment horizon that the investor is hoping to invest for. Is that true? Is it like a diminishing return that you want longer tenure, but not too long?

Jeff: [00:15:55] I think that that's one of the paradoxes that you face, because, by the time that you can establish that a manager is skillful, he or she may be in the process of making plans for retirement. And so, I think that that can speak to the advantages of team management. We've seen some firms, Dodge & Cox comes to mind, Capital Research comes to mind, PRIMECAP Management comes to mind, where it's really more of a team motif. I think that mitigates some of the pressure of relying as much on a single investor. Well perhaps is now long enough tenure that he or she is going to have to hand the baton off to a less senior, a less pedigreed manager and we've seen that sometimes that can be really messy. I mean, I think that probably the quintessential recent example of that is Third Avenue, a very storied investment firm. I still admire that firm in a lot of ways, but it's quite clear with the benefit of hindsight that when Martin Whitman, who is this legendary investor, still invests, to my knowledge. When he handed that off to his proteges, it didn't go off well. They weren't able to carry the torch, and obviously, that firm has run into a significant struggle in recent years.

Patrick: [00:17:19] One of the things that we've noticed is a rise in, I'll call it lumpiness of returns for different strategies that we monitor, that we manage. Obviously, we're factor-based so we're always focused on the performance of individual factors relative to the overall market. But I love your research on this idea that, winning funds very often look like losers. Or in many cases, some of the best funds over the very long-term look terrible for long stretches. I'm hoping that you could use the Sequoia fund because it's obviously a well-known manager, a well-known story. Maybe give us a bit of background on that and how that fund exemplifies this idea that winners very often don't look like winners.

Jeff: [00:18:02] Yeah, so I did a bit of research, this is some months back and really the impetus for this was a conversation that I had with a friend of mine, who I much admire who's in the business. His point was, using Sequoia as an example of a fund is languished, as long as that fund has languished, they clearly have lost the touch. There's a problem there and so what I did was, I delved in. I looked at funds that were quite old, had decades of track record under their belt and they distinguish themselves. They actually had generated I think positive excess returns, cumulatively versus their benchmark. I took a look to see how much time they had underperformed their benchmark and amassing that sort of success. What you commonly find is these funds that you would ordinarily say, "Hey, these are success stories," they have beaten their benchmark over an extended period of time. They spent many, many years looking up at their benchmarks. 10 plus year periods it was not uncommon for that to happen and so, which brings us back to Sequoia, which is a fund that we recommended not quite as strong as we did before it ran into some of its recent problems with Valeant. I think that's a firm that has a very ingrained discipline, a very research-intensive culture, an extremely committed and motivated group of managers, a very knowledgeable group of managers at that, I don't count them out. Certainly, the fact that they've had the difficult run that they've had in the last 10, 15 years, I don't think is disqualifying necessarily. It's among the reasons why we continue to recommend them, and I think there's perhaps a lesson in that. That lesson is that we have to be very, very patient as investors in many cases, and act with a great deal of resolve to have success in funds. For many of us, that's too much to ask for, and for those of us, we should index rather than invest in active funds.

Behavior Gaps in Fund Management

Patrick: [00:20:00] The numbers are pretty shocking about how often the base rates if you will, for even the best top let's call them top quintile performers sorted by excess return, how often they have 10-year periods of underperformance. It just goes to show that, and you can do this a million different ways, even shorter periods of time that you look back and you find the best funds, and you can always find periods when they did really badly. This adds to this problem of time-weighted versus dollar-weighted or investors' returns that I'd love to dive into next.

Jeff: [00:20:33] Sure.

Patrick: [00:20:35] Morningstar publishes what they call investor returns, which as far as I understand is, it's just dollar-weighted. I'd be curious to know some high-level thoughts on how bad this gap tends to be, the behavior gap if you will, and whether or not there are areas specifically within equities, but maybe outside of equities too where the behavior gap is lower. Are there characteristics of funds or ETFs that the investors in those have tended to behave better?

Jeff: [00:21:04] Yeah, so maybe we'll start with target-date funds, which I think are a success story in that regard. With target-date funds, one of the things that we've observed is positive gaps believe it or not. I would caution people not to read too much into it. I don't think that with target-date funds that there's something inherently virtuous about them, where people end up earning higher internal rates of return than the funds themselves. The cork here is that we had people that were steadily contributing sums to target-date funds that were tilted towards equities in the midst of an equity bull market and generally speaking, those are good facts. That's going to help you to generate a higher internal rate of return. You're going to earn more of the funds stated return. Why does this happen though generally speaking? Why do we see these smaller gaps with asset allocation products let's call them of which target-dates are one type? I think a part of it is situational, it's context. It's where they're offered. It's a more controlled environment, a defined contribution plan. Perhaps it's part of a broader advisory solution. Maybe you're getting some advice. Maybe you don't have the benefit of choice. Perhaps it's regimented. You're auto contributing. It's set as a default. You don't really have to think about it. I think those are among the reasons why these types of strategies benefit investors in this way. The other reason is, they're diversified. They rattle around a little bit less. What we have found generally speaking is that, the more an investment rattles around, the more likely it is to spook an investor. The more it spooks an investor, the more likely they are to inopportunely time their purchases and sales. And so you take those things together, the situational with the more intrinsic, the fact that they're diversified. I think that helps to explain why things like target-date funds have worked a bit better for investors over time than say your run of the mill equity fund, let alone a sector fund, which are going to be streakier and investors are going to have a harder time using.

What we have found generally speaking is that, the more an investment rattles around, the more likely it is to spook an investor. The more it spooks an investor, the more likely they are to inopportunely time their purchases and sales.

Patrick: [00:23:09] Given how hard it is to find managers, how wide the behavior gaps tend to be with people constantly chasing performance. I know you have I think four kids, how will you tell them to invest? Given all that you know and the numbers which are disheartening, to say the least in aggregate when you look at the success of investors picking active funds themselves, but then investors picking active funds, what will you tell your kids?

Jeff: [00:23:36] Yeah, I would tell them, unless they're willing to do the work, which is not insubstantial as you know, they should index. I think this holds for a pretty broad swath of investors, and this is a message that I've tried to hammer home in my own writings. If you're not really willing to do the work to research up the funds, and also if you don't feel like you've got the resolve that you're going to need to stick with funds in what can be some very uncomfortable and unnerving situations, then you're better off indexing. You're likely to achieve a better outcome. That's the first thing that I would tell them. The second thing that I would tell them is, hands-off. I think the fewer actions you take, trades you make, the better off generally speaking you tend to be, and certainly, that's the way I invest. I trade very, very seldom. What it really forces you to do I think if you're making some active investing decisions, you have to act with a great deal of forethought. You've got to do your homework up front, knowing that, I wouldn't say that it's an irrevocable decision that you're making, but it's going to be enforced for some time and you're going to have to live with that. It's going to make you take it all the more seriously, to begin with. I tell my kids, "If you're not going to do the work, index and if you are intent on doing it, make sure that you can live with that decision for years on end so you don't have to trade, which is something that ultimately can hurt you."

Patrick: [00:25:04] If there's anyone in the world that does do the work, it's you on managers and active funds of all types. If I were to play a fun game with you and say, okay, you have to look forward, let's say 10 years and you have two choices. If you win, you win some huge prize, $5 million. You get to either just buy either a target-date fund or a simple equity index. Or you knowing what you know and with your skill and experience evaluating managers, get to pick let's say five active managers within the equity category. Let's say that the S&P is the benchmark. What would you do? Do you think that you have done the work could identify active managers worth that bet ahead of time?

Jeff: [00:25:51] Yeah, a really good question. I think given the fact that success rates are as low as they are, and I'm a believer in mean reversion, I would probably take that second bet, which is to find five quality, actively invested funds, equity funds, and go with them. I think this has been a great run for passive funds, particularly US large-cap index funds in recent years. I do think there's an opportunity for active managers, quality active managers that don't charge too much, that don't overtrade, that apply a prudent strategy to make hay and so, that's how I would commit my capital.

Patrick: [00:26:30] If you were picking those five, obviously we've talked about some of the things that would factor into your decision. Lower fees, probably lower turnover, skin in the game for the managers, hopefully, some tenure. Beyond those things, which are mostly, I guess you could measure all of those things quantitatively, what would then be, if any qualitative aspects of your evaluation, what things are you looking for in a manager's process? Or any other considerations that you think are important for deciding on a good, what makes a good active strategy?

Jeff: [00:27:00] Sure thing, so I think that one of the most important things to me is, demonstration of resolve. Maybe I'll go back to one of the earlier quantitative data points that I ticked off in that shortlist, which was turnover rate. The turnover rate in and of itself doesn't mean a whole lot. I think it's really taking the turnover rate and placing it into the broader context of the strategy to understand why a manager trades so infrequently. That's what really can yield some insights into how it is they think about markets and opportunities. When we think of some of the most fabled investors, one of the lessons that they've tried to inculcate and those of us who follow them is that it's not the action that's important. In many cases, it's inaction. Really, it's acting with resolve, avoiding making big mistakes, and when you see your opportunity, you seize it. I'm not saying that a low turnover manager, a manager who trades infrequently exemplifies those qualities. But, I think that there's a greater likelihood that you're going to find some of those traits in them because again, they approach the investment process with a certain sense of irrevocability. That, what they're putting in the portfolio is something that's going to have to stay in the portfolio for four or five years on end. If that's the mindset that they have, they're going to be that much more careful from there. That's when you're going to start to dive in, and you're going to pick a name out of the portfolio. You're going to ask them, "Why did you add this? What are some of the other things that you were looking for in it that gave it its moat?" Those sorts of questions that you would ask in order to put together a fundamental thesis that describes the manager's strategy. The turnover rate is to me, something that's quite, quite important that I often go to when I'm looking at a manager.

When we think of some of the most fabled investors, one of the lessons that they've tried to inculcate and those of us who follow them is that it's not the action that's important. In many cases, it's inaction. Really, it's acting with resolve, avoiding making big mistakes, and when you see your opportunity, you seize it.

Patrick: [00:28:46] What do you think about the ideas of holding space and return space, or active share and tracking error as useful or not useful measures of looking at a manager, how do you think about those two variables?

Jeff: [00:28:57] Yeah, so I think they can be quite helpful in certain contexts. I would actually go back to our own star ratings, so I think that many people are probably familiar with the star rating that we put out. The star rating is based on funds past risk and load adjusted performance versus their category peers. It's a quantitative data point. It's backward-looking and so, what we have repeatedly said is that, it's a starting point for research. It's not a start, middle, and end. It's not something that you should use exclusively. I have the same sort of I guess, outlook towards things like tracking error or active share. I think that they can be indicative, but they're not defining. I don't think that I would look at two funds, one with perhaps a high active share and another one with maybe a middling active share, and reach any conclusions. I think what it would do is it might help to guide my research. One of the things that probably people I think ought to be aware of and AQR has done some nice research here is that active share can be a bit of a quirky data point. It's quite, quite sensitive to the benchmark that's chosen and so, depending on which benchmark you choose, you can arrive at different sorts of active share numbers and that can lead you to different conclusions about the same security. You do have to sweat the details a bit, but once I've got an active share number, it can tell me a little something about how to manage your approaches, the investing craft, the opportunity set, how cognizant they are of their benchmark. Once I know that then I can dig in a little bit deeper and understand how it is. Maybe they narrow down that opportunity set to arrive at a particular set of securities that ends up in the portfolio. Don't let it govern your diligence process. Let it maybe color it, inform it in a way, and guide you in your research.

Patrick: [00:30:50] One of the things that I think is useful about active share, which is, as you say, a complicated metric and certainly no panacea, it's not predictive from what we see of excess return. But one of the things that we see is, if you adjust the cost for active shares, you can find some interesting results. What looks like very low-cost solutions, can actually be quite a high cost when you back out the percentage of the portfolio that's just exactly overlapped with an hour of the virtually free total market fund say for example. That, a lot of the, and I'd like to get into what you think about factors and factor investing or smart beta, but a lot of the smart beta solutions look relatively low cost but have very low active shares. When you back out what you're actually paying for, what's different than a free benchmark or virtually a free couple basis point benchmark, it's a lot more expensive. That seems like an interesting use of active share that's pretty objective and clean beyond the more complicated choice of benchmark, predictive ability, and so on. Does Morningstar have an opinion on that idea of kind of active cost?

Jeff: [00:31:57] We think that's a useful way to look at it. We haven't built that into our products or our data points yet. We do have an active share, but we don't have an expense ratio that's adjusted as you described for the level of activeness if you will, within a portfolio. But I think that's a perfectly valid way to look at things and try to drive a sense of the value that you are accruing as an investor. One resource that I would point out, we've got a wealth of information, the various tools that we make available to investors, our website, Morningstar Direct, and the like, there is a website called activeshare.info. I think you're probably familiar with it as well. One of the professors that popularized ActiveShare, I think has developed this in partnership with an asset manager. You can type in a ticker, and I believe at the bottom of the dashboard, it shows you are an active share adjusted expense measure. It's a way for somebody to go in there and on the fly if they want to know this fund versus that fund, when I adjust for its active share, what does it cost me? This is a way they can do it for free online. I don't have any affiliation with it, but it's kind of a useful site for those who are interested in it.

How Fund Managers Can Build a Moat

Patrick: [00:33:08] Yeah. I've actually never heard of that. One of the original authors of that paper was the Notre Dame guy. I know the professors behind it quite well, so it sounds like a useful resource. If you're thinking about from the manager's side, and Morningstar writes a lot about moats at the company level. I think actually publishes some sort of quantitative score for moats. But if you think about managers as having moats, can you describe what might allow an asset manager or a fund manager to build a moat around their business or process that you think can help them outperform in the future?

Jeff: [00:33:47] That's a great question. Maybe we'll focus on the most prosaic and measurable, which is the scale and the benefit that it confers to investors, which is a cost advantage. We haven't talked a lot about Vanguard at this point in the conversation, but they're really the quintessential example of returns to scale. They built a moat by virtue of the fact that they are organized. They're basically mutually owned by the funds and therefore the shareholders of those funds. It's an at cost model. It's very, very difficult to replicate that, so there's an example of a moat in investment management. Now how about some of the squishier more qualitative things that one can do. I think that you can implicate a certain culture as an active manager within your firm, around research excellence, around a commitment to the shareholder. What you can do in the course of that is attracting the right type of client. I know that in some of the recent podcast episodes you've spoken at some length about Seth Klarman, who in turn has written I think, at some length about the importance of having the right types of clients. Now that's arguably a bit easier when you've got people that are maybe locked up a bit in an LP whereas we're talking here about 40 active liquidity vehicles of mutual funds. But we certainly have seen examples of firms that have been able to succeed by practicing what they preach, doing so through thick and thin. Really making sure that the philosophy infuses, permeates every single thing that they're doing. Probably the best example I can think of that is Dimensional, DFA as many know it, that's the shorthand that's used. You won't go down their headquarters and find a little moat around it, but what they've been able to do is propagate this philosophy and really inculcate it amongst the advisors who make their products available to end clients. They built a very durable franchise around it.

I would also point to Capital Research as another example of a firm that I think has done a really good job of building a durable investment and research-intensive franchise that puts the investor at the center of what they do. They're not a particularly flashy firm in a lot of ways, the funds don't trade a lot. They can be a bit corky in the way they're constituted. They don't rule out new products left, right, and center. They really stick to what they do, but in the course of doing that, they built a following. They built a certain investing identity and that's one of the ways they've been able to achieve a certain level of scale. Moving from the most prosaic and measurable, that being scale and returns to scale, to things that are more cultural and squishy. I think those are examples of how you can build a moat around an investment management business. Now, the other thing that we haven't talked about is distribution, and certainly, there's a moat that you can build that's predicated on distribution and the reach that your organization has. I can think of some organizations like Franklin Resources for instance that have a true global footprint. This gives them the ability to sell into a number of different end markets and verticals around the world. That's not something that you can easily replicate, and so there's something to that, there is a moat to that. I think for me though, that's become a bit more commoditized since more firms have become global, and maybe it doesn't have the same sort of panache and appeal that it once did. Investors are now so cause-conscious and so outcome focused that I don't know if they're necessarily as concerned about you being global. What they want to see is that you're conferring some benefit upon them principally in the form of low cost.

Patrick: [00:37:49] This mention of distribution is interesting because obviously there's a tremendous amount of effort that goes into selling mutual funds. Probably more effort into selling than research into buying. Are there strategies that you think are either effective and good in terms of how you distribute what that could be sales versus marketing? Have there been firms in your experience that do it well or the right way that others might want to emulate?

Jeff: [00:38:17] Yeah, definitely, so I think that a firm I mentioned done before, but I think that American Funds has done a pretty effective job through the years. They've been under some pressure, especially in the ETF passive's age really a post-global financial crisis. They've been under some pressure and dealing with redemptions, but I think they've done a pretty good job of helping their customers who have been primarily advisors to understand who they are as investors. What the value proposition is, and really driving that ethic through the way they introduce themselves to the market. They are probably a good example of a firm that's leveraged their distribution in an effective way. I mentioned Dimensional DFA before, I think that they've done a fantastic job of really building this flock of advisors that really subscribe deeply, fervently to what they do. Then bring that out to the market in a way that ensures that expectations aren't misaligned. Now they're not perfect, you can see there are some of their products like their emerging markets value fund, where the dollar-weighted returns and the total return of that particular fund last time I looked sharply diverged. That's an indication that perhaps it's been misused, but I think they've done a heck of a job of putting investors in their funds in a responsible way.

I would also focus on, we haven't talked too much about the ETF firms, we've talked more about the mutual fund firms. But, I think that Vanguard has done a phenomenal job of getting out and really building a following amongst advisors. They're really a phenomenon at this point within that market. I think it was tough sliding at first. There was still a bit of a schism between them and advisors who perceive them as a threat in some ways. Not only have they overcome that, now they have these advisors who are out there who are fully subscribing to what they do. It's quite remarkable. They've done a great job as is iShares. iShares was one of the first great success stories I would say in the ETF market, and they continue to do a great job of reaching advisors and other institutions that use their products that got a number of distributors, wholesalers distribution partners who really seem to understand what makes them tick as a firm or what the value proposition is. That's probably four or five examples of firms that I think do a particularly effective job of kind of weighting who they are as investors, as investment organizations to how it is they present themselves at the point of sale.

Patrick: [00:41:00] What's the most interesting manager that you've ever done research on?

Jeff: [00:41:03] I'm glad you ask that question. I was thinking about that just this morning as I was coming into the office. I would say that the most instructive experience that I ever had with a manager was, it was a manager I alluded to before, PRIMECAP Management. And so, for those who are familiar with Vanguard PRIMECAP, Vanguard Capital Opportunity, the PRIMECAP Odyssey Funds, that's PRIMECAP Management. They are a Pasadena, California based firm. They really got their start, they were an offshoot from Capital Research, again that's the advisor of the American Funds. They split up some years ago, set up their own shop. I had the opportunity some years ago as I went behind my year's analyst to cover them. It was actually a pretty pivotal moment for them. They had just set up their own proprietary family of funds. They were in the process of I think doing some renegotiating with Vanguard for whom they've self-advised several funds. They were also in the midst of a generational transfer all while carrying around tens of billions of dollars in assets. I spent over a year with two of the partners there, Joel Freed and Al Mordecai. They couldn't have been more generous with their time during that year plus. We spent a little bit of time talking about securities, but we spent much, much more time talking about the way the firm work, how they think about capacity, how they think about the generational transfer. How it is they inculcate their younger analysts and their up and coming portfolio managers in their philosophy incentives. For a younger analyst who is more accustomed to trying to do holding space analysis and understand what performance attribution was, the more bricks and mortar of diligence. Having this kind of much more encompassing conversation about a firm and what makes it succeed, that was extremely valuable to me. I owe a big debt of gratitude to the PRIMECAP folks who were very generous with their time. That was a great, great experience for me as an analyst.

Incentives Structures

Patrick: [00:43:04] How did they structure their incentives? I'm always fascinated with incentives basically, predicting the future how their structure determines a lot of what happens in all walks of life. What were there for their young analyst, how they compensated people, et cetera? What are some interesting ways that impressed you that they structured incentives?

Jeff: [00:43:24] They are very long-termed focused. They tie their incentives to a longer-term measure, so whereas I think it's typical on the industry to maybe look at a one, three, maybe a five year number. With PRIMECAP they're looking much, much further out than that, so that's the first thing. The second thing is a number of the managers eat their own cooking, so there is a direct alignment with the shareholders. Very, very important again. The third thing that they do is, they actually have the analysts run a sleeve of the portfolio. This is something that the Capital Research is popularized to a certain degree. They do a similar sort of thing, but by allowing the analyst to run a sleeve of the portfolio alongside the PMs, they have some skin in the game that way. Also, they take some ownership of what goes into the portfolio. You take those three things together which any one of them individually would be somewhat unusual by kind of run the mill Investment Management standards. You take the three of them together, that's pretty powerful.

Patrick: [00:44:26] One of the interesting ideas is trying to predict may be the wrong word, but think about what active fees and even how they're structured is going to look like in the future, let's call it 10 years out. Whether or not there is an ideal way to align the incentives of the manager who has to think about one performance and two gathering assets in the prevailing asset-based fee, paradigm that we live in now. Obviously gathering assets is largely about performance, so what do you think about that? One, what do you think it will look like? Do you think it'll just largely be the same 10-years sense where it will be asset-based? What do you think about performance fees? Just any thoughts on where we might be going, one where we might be going, but also what would be ideal. What could be ways that we could better align the active manager incentives with the investor?

Jeff: [00:45:22] Yeah, another great question, so maybe stepping back, trending fees, this is not a heroic forecast at all. Fees are coming down for active funds, so I don't think there's really any question about that. We talked earlier about what it is that might give active managers a tailwind they've been facing, headwinds. That's not going to change the next several declines in fees. We looked at fund fees earlier this year, the average active-weighted fee or I should say asset-weighted fee for funds was 61 basis points and on an equal-weighted basis, it was 117 basis points. If you focus on the top 1,000 share classes, it's around 64 basis points. The top 1,000 share classes are where you receive about 75% of the AUM. Compare that going rate for cheap equity market or cheap fixed income market beta, I mean that is a still pretty big gap there and we see investors are showing no signs of slowing their migration towards passive. I think fees are coming down. Now the second part of your question, how is it that we square up incentives? How do we align those better? I will tell you conceptually and they feel like I've been a bit of a voice in the wilderness on this, but I am actually a big fan of performance-based fees when properly structured. Now I want to caveat that. In 40 Act mutual funds, the way you set up a performance-based fee, it's fairly prescribed to you. It has to be a fulcrum fee so there's a base fee and then there's a fulcrum that sort of flaps around at the top of that. Typically, I find that's pretty limited in terms of what you can do to really, truly incentivize a manager to focus on say long-term performance. Why is it? It's because the base portion of the fee, which is fixed and generally speaking you're going to get it within a certain range over time, that dwarfs the fulcrum amount that you're going to get. It really does not act as much I think of a molder behavior so to speak. The concept of performance-based fee and getting away from the asset-based fee, I think that has to be a part of the future of investment management. Especially if base fees, which I just quoted to you now, that's 64 or I should say 61 basis points asset-weighted. If those are coming down, the managers are going to have to find another way to bring home the bacon so to speak. And so I think a performance-based fee is an equitable way for them to do that. I'm answering this as my characteristic lack of brevity here Patrick.

Patrick: [00:48:07] That works.

Jeff: [00:48:08] One of the things that I would point out is, so I think that there are many things to quarrel with when it comes to hedge fund fee structures, which generally speaking are ridiculous. But I do like the fact that, there's a pretty big performance-based component. Now one way to argue when you're getting 2% per annum come hell or high water, you're not going to have to worry too much about whether you get the other 20% of performance. I would point out that, when you do have a meaningful performance-based component, what it does do is I think make you a bit more thoughtful about your strategies capacity. That gets back to thoughtfully constructing a performance-based fee arrangement. If you do thoughtfully construct it and the performance and the strategy really is a meaningful input, how it is you're compensated ultimately as a firm or as a manager, then you're going to be a whole lot more thoughtful about managing your capacity. You're going to shut the strategy off before bloat set in, which is not something that managers to this point have a really, truly impressive record of doing. Generally speaking manager shut strategies when it's too late and bloat has already set in or it's soon will. That's one of the reasons why we see mean reversion amongst mutual funds. I think if a performance-based fee could help managers, can make them more disciplined about capacity management, that could be a big win for investors.

Transparency in Fund Management

Patrick: [00:49:34] You have a really interesting point about the idea of transparency, which in general has been viewed as a pure positive that, the more transparency, the better. Could you expand on that and why that may not be the case?

Jeff: [00:49:48] Sure and I have to tread carefully or just given the fact that my employer, I mean transparency is an animated principle for us. The firm has been built on it and I and others here, believe strongly in it. Having said all of that, I think that transparency is wonderful. Having that look through, being able to monitor, I mean heck our team wouldn't be able to do the work that it does without the transparency. It's afforded by managers and also through regulation, but it can hurt us too. If we're too obsessive about looking at our portfolio and seeing how it's done over shorter periods of time. This one's true, not just for investors and the fund, but the PMs themselves. We've heard figures as estimable as Warren Buffet kind of talk about this notion and I'm paraphrasing here that, you should be prepared in making an investment for the stock market to close for some period of time starting tomorrow, say for five years. Approach it with that level of seriousness and again you use that word, irrevocability. I think what he's getting as is, being able to watch something squiggle around on a screen is not really what counts. What counts is the forethought that goes into investment, doing your homework upfront. Sure check in occasionally, especially to rebalance may be on an annual basis, but don't use transparency in excess where you're going to be getting yourself so worked up that you're going to be over transacting. Then back to one of our earlier themes, the gap between the dollar-weighted return and the actual return of your investments, that sort of gap opens up when you overtrade. One of the reasons why that happens is because you've got to look through your investments and you see how they do over a short period of time. It scares you or you get greedy and you make a change and that's why transparency, it's a virtue, but if we use it in excess, it could really hurt us.

...being able to watch something squiggle around on a screen is not really what counts. What counts is the forethought that goes into investment, doing your homework upfront.

Patrick: [00:51:51] Some of those behavior gaps are just so terrible to look at. You pick up the quote on Morningstar and you see these five, six, 7% annualized behavior gaps over pretty long periods. Often times it is these higher flying in many cases growth funds or even sector funds that have an amazing run. Money piles in and then mean reversion rears its head. Are there any ways do you think of helping people avoid that problem? The one that obviously springs to mind is to use the stick not the carrot, and heavily penalize people for withdrawals immediately after they invest to try to engineer a longer holding period. But of course, that rife with problems that there are exogenous variables that you can't account for with that. People need the money for some reason and they shouldn't have to pay a penalty. Are there other ways that we could try to stop this horrendous behavior gap and of course you could argue that the active management committee is reliant on stupid investor mistakes, to produce opportunities for alpha? Thinking about that gap, what do you think? Should we structure things differently to discourage people from overtrading?

Jeff: [00:53:05] I actually feel that entry and exit fees applied judiciously can make a good deal of sense. I am not opposed to those at all. Like you say, I think that gives investors and those that represent them something to think about before they go in. Now, I'm certainly not advocating for big front end loads or punitive redemption fees, which is some of the direct that you'll see on certain types of products. I think that that's very unhelpful, in some cases it can be predatory, so that's not what I'm suggesting. But, we've seen some very respectable firms and I would include Vanguard in this. They are certain of their funds if I'm not mistaken, where you actually have to pay. It's a nominal fee, but it is a fee all the same to ensure that you're not here in a day, gone tomorrow. The more resolute shareholders, the basic shareholders who stay in it so they don't have to pay for that baggage of you, entering and exiting in the fund having to transact. Really I have no quarrel with that at all as long as it's judiciously applied. In terms of guidelines that we can follow as investors or in the case of advisors as intermediaries in that process, I think that one telltale huge warning sign is a big influx of assets into the strategy concern. We've seen this time and again. Whether we're talking about tactical mutual funds following the global financial crisis, I could think of a few pretty popular liquid alternative funds around 2011 that gathered just torrents of assets. It really became more of a story than an investment thesis, where there was quite a bit of tag along. And so, I think in situations like those, we've got to step back, pause, ask ourselves what our thesis is so to speak for that investment, and hopefully, that's enough to keep us out in those sorts of situations. Then the other thing that we have to do is just make sure that we are entering with the appropriate mindset and expectations. That when we're representing clients, we're leveling with them. If it's an active fund we're saying, "Hey, this is not something that we're going to own for just three or even five years. This is something that we're going to own for some period of time." There's probably going to be some underperformance along the way, because that's part of the price of praise of outperformance in some cases. If we do that, then it prevents some of this inopportune buying and selling.

Patrick: [00:55:42] What do you think about the value growth paradigm? Obviously Morningstar, I think the Style Box dates to 1992 soon after the Fama-French research came out also talking about value. I mean in the grand scheme of things, that's not that long, but it's become such a pervasive way of thinking about and categorizing investments managers, et cetera. Now we have the rise of factor investment which is, it's less about growth and more about value, quality, momentum, defensive, some other categories. Do you think that this dichotomy, this value growth dichotomy makes sense? Do you think it will last in this rise of new factors where growth really isn't one of them? How do you think we'll categorize funds in the future?

Jeff: [00:56:26] Yeah, that's a great question. We actually and not to be a commercial shield here, but one of the things that we did recently and this is a credit to some of my colleagues in the quantitative research side led by Lee Davidson, we actually put out a commercial risk model. It's part of one of our tools and it actually expands numerous different factors so we've moved well beyond the nine-box, style box grid that many people associate us with and that we're very proud of. But I think it's an acknowledgment of the fact that classifying funds and their various attributes, goes beyond size and even value growth. We have to consider some other things and you named a few of those. We've got momentum, quality. We have a few of our own proprietary factors that we've developed. You mentioned moat before. There's valuation. There's the uncertainty of it associated with the intrinsic value estimate of a particular security, that we also promulgate. These are all efforts that we have made to recognize that, there are more sophisticated ways that we can go and classify securities and try to attribute their performance, and so that's why we put the risk model up. Made it available to some of the users of our researching tools.

Jeff's Most Memorable Day

Patrick: [00:57:48] Last two questions are a couple of my favorites. The first is, if you had to pick, I already asked you about your most memorable experience with a fund manager. If you had to pick an individual day that is your most memorable throughout your professional career, what would it be?

Jeff: [00:58:03] I would say this was when I was a newly mentored analyst back 2002 if I'm not mistaken, I could have my timing wrong. We gathered around a TV in our headquarters and we watched Elliot Spitzer basically unveil his allegations of market timing against a number of mutual fund complexes. To this point, I think that generally speaking the fund industry should be pretty proud of what it's offered to investors. It's given them access to the markets. In a reasonably priced way, there's always room for improvement. I think the market is seen to solving that problem, giving the shift to low-cost investments. But generally speaking, the industry has done a good job, but I think at that juncture it's fairly lowly wide. It hadn't had any sort of widespread scandals, and so that really stands out for me in a couple of ways. First, it happened. The industry hadn't had that sort of traumatic experience, and then also it was the way we responded as a firm. I'm really, really proud of the colleagues that I work with, and was proud of the way they responded. They responded by identifying a number of firms that had engaged in these activities and warning investors away from them. That was not an easy thing to do. You can imagine the reaction it elicited from some of these firms, but it was the right thing to do. I think it was very much congruent with the investors' first ethic that we try to make sure that we put front and center. It was certainly a pivotal moment in the history of the industry, and it was also very indelible moment for me and my career here at Morningstar. Learning what it is that defines us as researchers, and the responsibility we feel towards the users that we try to serve so that's a pretty memorable day for me.

Patrick: [00:59:56] My last question is, another one I ask everyone and I'll put a little twist on it and I'll let you choose the way you want to answer it, which is this idea of kindness. Curious to know what the most kind thing someone has either done for you or kindest thing that you have done for somebody else. You can answer either or both or I guess neither.

Jeff: [01:00:18] Yeah, so let's start with the first one. I mean I think that probably the kindest thing that someone has done for me professionally and this goes back to an earlier juncture of my career when was in public accounting. I started my career at what was then known as Arthur Andersen, and I had an opportunity to catch on with an internal group there called the Professional Standards Group, which was the firm's really resource expert on technical accounting and auditing matters. It was a very, very prestigious group. I was a young kid, not polished at all and they took a chance on me. I spent the next six years of my career working for these extremely accomplished, unbelievably hardworking partners in this group. They did not have to do that, and they did that and I got to work at their feet and learned a great deal from them. They were willing to tolerate me for that half dozen years, so I have to thank my former colleagues at Arthur Andersen, you know John Stewart, Amy Ripepi, Rick Peterson, the late Benjamin Neuhausen and so forth who were in that group at the time. I thank them for doing that for me, it was a very, very nice gesture. Then the nicest thing that I've done for other people, maybe we'll step out of the professional realm here. You alluded to it before, I have a young family, four children. I would say collectively I try to make every day better than the one before it. Help our kids learn and show them the way, and lead by example most of all by showing them the value I hope of empathy and understanding different circumstances that people live in. We're very lucky that we meet a safe and comfortable life, but hopefully they're growing up to understand that not everybody is in that same situation. One day they'll be able to inculcate their own children in that same sort of mindset. That's an ongoing effort and we'll see how it turns out, but that's my big project of trying to give back a little to my children.

Patrick: [01:02:29] As a parent, I fully endorse that one. There's nothing better than that, and so I have one bonus question.

Jeff: [01:02:37] Sure.

Patrick: [01:02:38] Your Twitter profile is the inspiration for it, so your name is a reference to Sonic Youth and your picture's Daft Punk. If you had to choose, let's say two bands that you encourage people to check out that they probably haven't heard of before, as a music lover and avid music follower, who would you recommend?

Jeff: [01:02:59] Sure, oh that's such a great question, what fun, so maybe I'll focus on it's an LA punk band. Their heyday was really in the 80s and they have a very, very spiffy name. The name is X and the record I would recommend is... When I bought it, you could get the two records together, Los Angeles, Wild Gift of the two of those I'd probably recommend Wild Gift. I think that's a great, great record. Then the other one which is a bit of obscurity but for people that are interested in some of the sounds that came up in the old rock era, these Walls of Sound and so forth, you found some of the inspiration for that overseas. Probably the most famous of those bands is one named My Bloody Valentine, they put out a very influential record called Loveless. But there was another band called Ride, which I think some people are familiar with but they're not quite as well-known as My Bloody Valentine. They put out a record which, if my memory serves is called Nowhere which I love. It's a very rewarding listen, real hooky stuff. There's a lot going on in the background and walls of guitar and so forth I think I quite enjoy that one as well so X and Ride.

Patrick: [01:04:28] Fantastic. Hadn't heard of either, so I'll definitely check them out. Well, Jeff, this has been a blast full of really useful information from someone that sits in a very interesting seat as I said at the beginning. So thank you, one for your time and all your perspective I think that everyone listening, whether it's a financial advisor or an investor or a money manager, can find something useful in our conversation. Thank you so much for your time.

Jeff: [01:04:50] Oh thank you, it was my great pleasure.

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