Morningstar Magazine - December 2017/January 2018 - 12

Dispatches

You Get What
You Measure Better
standards align
manager incentives
with shareholder
interests.
PHILLIPS CURVE

Don Phillips

The mantra of management is that you get what
you measure. If you want more employee
face time in the office, measure their entrances
and exits. If you want greater safety in the
workplace, measure the number and severity
of accidents. It stands to reason; people respond
to the pressures and incentives placed upon
them. Mutual fund managers, of course, are no
different. If you incent them to generate high
yields, they will stretch for added income. If you
reward short-term performance, but ignore risk,
they will shoot for the moon.
The problem in the mutual fund world is that for
years these incentives were applied for the
apparent benefit of the asset manager and not
necessarily for the benefit of fund shareholders.
It was commonplace to base portfolio manager
compensation on the size, rather than the
performance, of the fund they were managing.
Bigger rewards for those shouldering a bigger load
make sense within the halls of the management
firm: A bigger fund is a bigger profit source
and all of the firm's employees know that. But
fund shareholders don't care about fund company
profits, they care about their own experience.
They want their portfolio manager researching
securities, not schmoozing with brokers, but the
manager was often incentivized to do just the
opposite. While better performance should in time
bring more assets, that's a tenuous link that
may take years to realize. Getting a broker to sell
more shares today has an immediate impact.

12

Morningstar December/January 2018

When fund companies did include performance
in managers' evaluations, it was too often focused
on the short term and downplayed or ignored the
risks taken to achieve that performance. Fund
companies knew that hot performance generated
news coverage through quarterly leaders' rankings
and profiles. To be a top fund in a calendar year
was certain to generate lots of press coverage. As
the head of one major fund company once told me:
"A management consultant told us that the way to
move the needle in the no-load world was to have
a fund rank in the top decile of its category for the
year, so we aligned all our manager incentives to
generate top-decile annual returns." In the process,
risk was discounted, costs downplayed, and any
performance outside the calendar year ignored.
The results were entirely predictable: The firm got
more top-decile results, but it also got more
bottom-decile results. Their managers who were in
the middle of the pack in November would take
crazy risks to try to jump up the performance
rankings before year-end, knowing that if they won,
they'd get big bonuses-and if they lost, they'd
get a clean scorecard on Jan. 1. In pursuit of new
shareholders, the firm incentivized managers
to regularly blow up their funds and damage their
long-term risk-adjusted performance-just what
existing shareholders would not want. And the
ultimate irony was that the new shareholders they
did attract when successful were among the
most fickle imaginable. They loved the fund when
it was hot and abandoned it as soon as performance cooled.
Fortunately, the incentive situation has improved
considerably in recent years. The Securities and
Exchange Commission now requires fund
companies in the United States to disclose the
incentives embedded in their managers' compensation. While these disclosures may not be widely
read by shareholders, the fact that Morningstar
and advisors and consultants can access them as
part of their stewardship assessment of a firm
makes a huge difference. Fund companies now are
far more likely to link manager compensation
to longer-term performance that often includes
some sort of risk assessment. Moreover, it is
now required that fund companies disclose in
broad buckets the level of a manager's own
investment in the funds that they manage. While

the industry fought this disclosure tooth and nail,
there's no better way to align manager and
investor interests than to make sure the manager
is also a shareholder.
Finally, it's worth considering the role that
Morningstar's ratings have played in manager
incentives. The Morningstar Rating for funds, or
star rating, has limitations. The stars are a grade
on past performance-and past performance
may not always be prelude to future returns, as
many variables can change in a fund or in the
investment environment in which the fund
operates. But as grades, the stars create incentives
that are much better than the short-term leaders
and laggards lists that they have displaced as
evaluation tools. The stars are long-term-oriented,
include a risk measurement, and are highly
correlated with expenses. They thus encourage
fund managers to keep costs down, to avoid wild
risks, and to think long term. In short, they create
precisely the incentives rational shareholders
would want their fund managers to operate under.
Morningstar Analyst Ratings go even further
in their attempt to create appropriate manager
incentives. They are even more highly
correlated with costs, putting more pressure on
managers to lower fees. They also embed much of
Morningstar's stewardship work, rewarding
management's alignment with shareholder
interests through investment in their own funds
and favoring fund shops that have created better
investor experiences by shunning faddish
concepts that are easy to sell, but often blow up
on shareholders. Simply put, rational shareholders
would far prefer their fund managers to aspire
to be a Morningstar Medalist than to top the
short-term performance derby.
At Morningstar, we've tried to make a positive
contribution to shareholder success by pointing
the industry toward better behavior, lower
fees, and more disclosure. In my opinion, we've
had much success over the past 30 years in doing
so. There's still work to do, but we won't stop
trying to measure and reward those fund company
behaviors that most benefit investors. K
Don Phillips is a managing director with Morningstar, and
a member of the editorial board of Morningstar magazine.



Table of Contents for the Digital Edition of Morningstar Magazine - December 2017/January 2018

Contents
Morningstar Magazine - December 2017/January 2018 - Cover1
Morningstar Magazine - December 2017/January 2018 - Cover2
Morningstar Magazine - December 2017/January 2018 - 1
Morningstar Magazine - December 2017/January 2018 - 2
Morningstar Magazine - December 2017/January 2018 - Contents
Morningstar Magazine - December 2017/January 2018 - 4
Morningstar Magazine - December 2017/January 2018 - 5
Morningstar Magazine - December 2017/January 2018 - 6
Morningstar Magazine - December 2017/January 2018 - 7
Morningstar Magazine - December 2017/January 2018 - 8
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Morningstar Magazine - December 2017/January 2018 - 11
Morningstar Magazine - December 2017/January 2018 - 12
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