Index Spotlight - Q&A with Don Phillips, Managing Director of Morningstar By John Spence October 7, 2002

Chicago-based Morningstar recently announced the availability of 16 proprietary equity indexes that correspond to its popular style boxes, which are recognizable to most mutual fund investors. We sat down with Morningstar managing director Don Phillips to discuss the new benchmark family. Mr. Phillips joined Morningstar as the company's first mutual fund analyst and soon became editor of the company's flagship publication, Morningstar Mutual Funds. He has followed mutual funds for Morningstar since 1986 and is one of the industry's most respected voices.

Q: It's a crowded field out there for index providers, and you're entering the game rather late. Can this be an advantage? What will set the Morningstar benchmarks apart, aside from a strong brand name?

A: There are some advantages to having seen how others have done it, and you can select from best practices. Best practices for indexes are really still emerging. It seems that indexes are being used for different purposes today compared to their historical roles.

The first generation of indexes like the Dow or S&P 500 were used to gauge the general direction of the market, or to measure daily or quarterly or annual returns.

More recently, second-generation indexes were designed to replicate the behavior of active managers. Those would be the early style indexes, like the S&P/Barra indexes, for example.

There's the possibility now for third-generation indexes that do more than just track the market or replicate broadly the way growth or value managers behave. Instead, they're designed to map out the playing field on which active managers operate, or in which passive strategies can be deployed. Our indexes are organized a little differently because we've got middle "core" zone, making the growth and the value more extreme.

There are other advantages to coming later in terms of execution. Things like float weighting adjustment [an index weighting scheme that excludes shares not available for purchase on public markets] are becoming more accepted because indexers are demanding criteria now that weren't even necessarily imagined by index providers decades ago.

There have never been so many good investment options as there are today, but the reality is that people are not making good use of them.  -Don Phillips, Morningstar

Q: Do the Morningstar indexes generally correspond to the familiar 9 style-box framework? On the surface, it seems the most important distinction of the Morningstar indices is the addition of a "core" classification for style. Traditional indices only have two categories for style - growth and value - while Morningstar has three. What are the benefits of that system?

A: The new indexes do correspond to the style boxes. One unique thing we bring to the table is the indexes are designed with the goal of helping the portfolio construction process. We didn't set out to replicate manager behavior, as many second-generation indexes did. Instead, we wanted tools that would be helpful for attribution, and for portfolio construction and analysis. That's a slightly different approach. Most of the existing style indexes attempt to define how active managers view value or growth and come up with a benchmark for them.

We identified what growth or value characteristics existed in the market and came up with purer indexes. It may make our benchmarks slightly less usable as a benchmark for an active manager, but we think this makes them more useful as attribution or portfolio-building tools. Most of the existing style indexes end up watered down; they throw in a lot of growth characteristics into the value index, and vice versa. They recognize active managers are not always extremely disciplined in their execution of a growth or value style. We wanted a purer distillation of growth or value. This is useful for understanding how these two different forces are pulling on the market. If the indexes are licensed for investment products, you end up with a more potent portfolio-building tool than a watered-down index.

Everything fits within the framework of our style boxes. We're classifying stocks and funds according to the exact same metrics we're using to define our style indexes.

Q: So everything is complimentary.

A: Yes. When I look at the mutual fund landscape today, I don't think the problem is that people are buying bad funds. There have never been so many good investment options as there are today, but the reality is that people are not making good use of them. They put all of their money in the growth and tech-heavy funds in 1999, just in time to see the style go out of favor in 2000 and 2001. We wanted to do something that would contribute to the portfolio construction, analysis, and monitoring process. The key thing is to get people focused on the building blocks of portfolio assembly.

My biggest pet peeve with indexes is how they are seen in the public light today. The nightly news and dozens of websites always report on the Dow, the S&P 500, and the Nasdaq, as if these three were meant to be used together to measure a portfolio. And the three exchange-traded funds tied to these indexes control the lion's share in terms of assets, which suggests that some people might be building portfolios with them, but they weren't designed for that. Each was designed for different purposes, either to replicate the market, or in some cases even to promote one exchange or another. We think it's time fund managers stop serving indexes and that indexes start serving investors.

Q: It's important for passive managers to understand index methodologies, and on the other hand index providers must understand the needs of their customers. In developing, maintaining, and licensing indexes, are Morningstar's research background, and its relationship with the industry, assets?

A: Our indexes are rules-based and completely disclosed. Securities aren't picked out of some black box or magical hat and thrown into the index.

Our understanding of the industry has really shaped how we approached building the indexes. We didn't want to simply create a series of indexes that replicate what managers do, and make that available through passive funds at a lower cost. That's certainly an advantage to indexing, but when you get right down to it, it's a fairly hollow one. You're simply shaving a little cost out of the equation. It's not necessarily something that helps people make better investment decisions.

We tried to come up with indexes that were more than flexible benchmarks that show what managers are doing today. We're trying to define the playing field on which active managers do their work, and help people understand how managers are navigating their terrain. Hopefully this will elevate the debate over which activities are adding value and which aren't, and result in a set of tools that will help people assemble and monitor portfolios.

There's a tendency out there to compare individual funds in a portfolio to recognized benchmarks like the Nasdaq or the S&P 500. A lot of investors think that if a fund is lagging a particular benchmark, then it should be removed from the portfolio. I think that's contributing to the horribly counterproductive asset flows in the fund industry.

Q: What's your response to some of the changes Vanguard index fund manager Gus Sauter has suggested regarding benchmarks?

A: So much of what he said makes sense, and he's obviously a smart person who's in the middle of things. Many of the things he's suggesting are advantageous. But it's all based upon his goal, which is to create a lower-cost alternative to active managers. That's fine, but it's only one interpretation of what indexes can do. Indexes can also be pure distillations of what actually happens in the market. Mr. Sauter basically says markets don't define style or size, managers do. I'm not sure I buy that. General Motors isn't a large-cap stock because managers decide it is. There are characteristics such as price-to-book ratios that appeal to different managers. Amazon.com didn't become a value stock because [Legg Mason Value Trust fund manager] Bill Miller bought it.

One viable role for indexes is to replicate what active managers do, so that it can be repackaged at a lower cost. But there's the potential for indexes to move from flexible benchmarks to fixed signposts that give investors a better sense of the playing field on which an active manager makes decisions.

Q: Exchange-traded funds have been a strong growth area for the mutual fund industry that has provided new opportunities for partnership for index providers. Might we see ETFs based on the Morningstar indexes?

A: We did announce that UBS licensed the indexes for ETFs, but those plans are on hold for the moment. They may or may not follow up on those plans, but right now the ball is in their court.