Q&A: DON PHILLIPS — "FIDUCIARY RESPONSIBILITY IS ABDICATED WHEN YOU START TALKING ‘PRODUCT’"

Don Phillips has virtually grown up with the mutual fund industry. The 35-year-old president of Morningstar Inc. began with the Chicago-based fund research firm 12 years ago as its lone analyst and went on to become editor of the firm’s flagship Morningstar Mutual Funds publication.

Mr. Phillips helped develop the firm’s style box and category rankings, as well as the risk-adjusted star ratings for which Morningstar is best known.

He has forged a reputation as a respected industry observer and advocate for the individual investor. He’s also something of a throwback, chiding the fund industry for forgetting its investment-company roots in the quest to build branding and distribution.

His opposition to the truncated prospectus format recently approved by the Securities and Exchange Commission last year prompted the SEC’s director of investment management, Barry Barbash, to label Mr. Phillips’ views “naive.”

On that and other issues, though, Mr Phillips has stuck to his guns.

Q You’ve been very critical of the SEC’s profile prospectus.

A Clearly, any move to better communicate what funds do is incontrovertible. Who’s going to argue about it? It’s like taking the anti-motherhood, anti-apple pie side of the debate.

What worries us is where they hand you, say, 12 items of information, and they’re basic things like yield, past return, sales charges and things like that. We have no problem with that being a table, say, at the front of the prospectus.

What worries me is all the stuff’s that’s getting omitted from the main document that people see.

Q You’re concerned that if there’s some sort of a shorthand version, that’s all people are going to read?

A That’s right. In the early versions, there’s been no mention of the corporate structure of funds.

We actually suggested a paragraph that you put front and center in the profile prospectus: When you buy a mutual fund, you become a shareholder in an investment company. And with this comes certain rights and protections, chief among
them: a largely independent board of directors whose main role is to safeguard your interests.

Clearly, everyone agrees the SEC is wearing a white hat here and doing something good.

Our argument is simply that they don’t need to be the only ones wearing the white hat. Enlist the independent directors, enlist the financial advisers, enlist the media — have a lot of people looking out after investors’ interests.

Q The industry uses product terminology all the time, talks about shelf space, et cetera. Why is it important to distinguish between consumers and shareholders?

A The onus shouldn’t be on Morningstar and Don Phillips to say, ‘Gee, why is this stuff still important?’ It should be on the leaders of the industry, the SEC commissioners, to say all the terminology the industry has been based upon, as codified in the Investment Company Act of 1940, no longer applies, and there’s a valid reason why we should switch.

Read the ’40 Act: You’ll see nothing about distribution channels. The word “product” isn’t used, the word “customer” isn’t used. All the way through, it’s “investment company” and “shareholder” and “fiduciary responsibility.”

That whole notion of fiduciary responsibility is abdicated when you start talking “product” and “shelf space” and “distribution arm.”

Q Isn’t it kind of inevitable though? With more than 8,000 funds, it does sort of become like cereal on the shelf, doesn’t it?

A This is a very dangerous time for the industry to be kind of rewriting its walking papers, when everything’s flying high. That worries me.

As I say, I may be the only person in America who’s worried about it. But the odd thing is, we’ve been ridiculed for doing it, including by some of the top regulators. And that’s what’s scary. Because we’re just quoting chapter and verse from the existing rules, as they’re written.

Q Assess the performance generally of independent directors.

A On the one hand, you have to say they’ve
done something very right in the sense that the fund industry has remained relatively scandal-free. It’s tough to know, though, because so much of what they do is behind closed doors.

And clearly, rising management fees — the minimum management fee has risen every decade since the 1940s — is a very unfortunate trend. If you look at the publicly traded mutual fund companies, the profit margins are outstanding.

Q They’re basically obscene, aren’t they, sometimes more than 50%, even 60%?

A Well, they’re very high. The thing is, profit margins aren’t really a moral

issue. But in the fund industry, it’s a little different. If Sara Lee has very high profit margins, it doesn’t make the cheesecake less good. Whereas for mutual funds, by definition, as the profit margins get higher for the fund management company they must decline for the investor, so it makes their product, if you want to use that word, less attractive.

So the fact that fees have gone up has got to be troubling and I think that it

suggests that perhaps directors

could have done more to represent shareholders.

VITAE

Don Phillips, 35, president, Morningstar Inc., Chicago.

Employees: 350

Revenues (1997): $40 million

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