Morningstar: Friend or Foe of Shareholders?

The annual Morningstar conference is slated to be held this week in Chicago. So as over a thousand people gather there, it may be appropriate to ask whether Morningstar has the best interests of mutual fund investors in mind when it comes to conducting its daily business.

Morningstar straddles the line between offering shareholder advice, while also catering to the lucrative mutual fund industry. That is a difficult balancing act to maintain, especially when it comes to giving objective advice which is then supposed to be balanced by the much more lucrative practice of rating mutual funds, writing manager critiques, and booking advertising from fund companies.

This is a classic case of editorial balance, and in too many cases, I believe Morningstar has tilted its activities in favor of fund companies, its list of preferred managers, and fund rankings which have a built in bias to the upside.

For instance, 20% of the funds in any category (small-cap value, large-cap growth, for instance) get a 5-star rating no matter what the entire category universe has done. Fund ratings are a lucrative business because the mutual fund industry has become so commoditized that fund companies fall all over each other each time the new ratings are released.

In turn, the fund company then pays licensing fees to the fund company to use their new rating to publicize their fund's performance, which is inevitably temporary. This is a great business since the star rotation is constant, as are the licensing fees to Morningstar.

Similarly, too many of the fund analyses seem toothless. Morningstar "analysts" often do not have any CFA or advanced analytic credentials, plus they seem to bend in favor of the fund industry.

Profits versus Objectivity
This is not surprising and there have certainly been similar objective lapses in other financial evaluation companies. One of the best examples happened with devastating results when equity analysts fell under the sword of investment bankers during the Internet IPO frenzy of 2000. In that instance, analysts were forced or succumbed to peer pressure, to soften critical analysis of IPOs which had weak or no business models. This conflict of interest by many analysts, including Henry Blodgett and Mary Meeker, helped inflate the Internet bubble.

There is now a bubble in mutual fund performance critiques from supposedly objective sources. Too many funds, and the entire load-fund industry has received a pass from "objective" sources, including too many fund reporters.

In one case, a Morningstar review of star portfolio manager Bill Nygren's Oakmark Fund concluded that there was no significant change in Nygren's decision-making process, even though the fund (OAKMX) suffered a 32% loss in 2008. One of Nygren's top holdings was Washington Mutual Bank which was then in the process of suffocating under high-risk mortgages and credit card operations.

Nygren is a favorite of Morningstar and is speaking at their current Chicago conference, but the Morningstar critique never presented any deep discussion of how he generated his holdings, changes in his staff support, his decision making inputs, or why he chose to hold on to poorly-managed companies or deteriorating sectors. In short, the Morningstar critique just seemed to lack the facts to support the analyst's opinion that nothing had changed at the Oakmark Fund despite the 32% decline.

Shareholder Advocates?
While it's clear Morningstar supports the mutual fund industry, their record in advocating fund reform is not clear. Since Morningstar is a powerful force in the industry, and makes millions from individual investor subscriber subscriptions to its premium advisory services, you would think they would take some forceful positions about such controversial issues as how 12b-1 fees are abused.

While they certainly have some articles on the importance of fees, they have not linked high fees, low fund performance and the need for 12b-1 reform.

As a result, it's perfectly fair to ask Morningstar what side of the fence they are on when it comes to making the tough corporate and editorial decisions which favor either shareholders or the mutual fund industry.

As the 2000 Internet stock analyst scandal proved, you cannot serve two masters.

--Chuck Epstein
cepstein@prodigy.net