tjbresearch.com
Tuesday, July 21st, 2015
behind the curtain

Last week, Morningstar announced that the DoubleLine Total Return Bond Fund was “not ratable,” repeating its assessment from the previous year.  The battle between the most prominent fund rating firm and Jeffrey Gundlach, the manager of the fund, seems likely to continue for quite some time.

According to published reports,Financial Times | Including this one, which carried the title of “Morningstar: A force to be reckoned with.” the bad blood began just before the formation of DoubleLine, when Morningstar publicly sided with Gundlach’s previous employer (TCW) after he was fired.  Accounts of the spat usually focus heavily on 2011, when Morningstar only gave the fund a “neutral” rating and did not award Gundlach its “manager of the year” award despite outstanding performance.

Sometime thereafter the lines of communication between the two were severed by DoubleLine, citing what it felt were errors in analysis by Morningstar.  A recent Wall Street Journal articleWall Street Journal | “Bond King Feuds with Morningstar.” said that over time DoubleLine came to the conclusion that Morningstar “didn’t understand fixed income.”  (Despite the lack of a rating from Morningstar, money has continued to pour into the fund.the research puzzle | DoubleLine’s total fixed income assets are now approximately at a size that would cause a firm “to have to say ‘yes’ to the marginal securities,” according to a 2010 statement from Gundlach.)

In the WSJ article, a portfolio manager at another firm said, “There’s probably enough information to constitute a sound decision without having to rely on Morningstar.”  If you’re a regular reader of this blog, you might imagine that I’m interested in what makes for “enough information to constitute a sound decision.”

Because of his appearances at industry events and his frequent webcasts, advisors and investors feel like they know Gundlach, just as they felt like they knew Bill Gross, the previous holder of the “bond king” title.  But what do they know, really?

In general, the impressions of advisors and investors regarding an asset manager are formed primarily based upon the historical performance record.  The context for that performance and any evidence about investment process, culture, and other hard-to-identify variables usually come directly from the managers themselves.  (Those messages subsequently find their way into reports and discussions of others, often verbatim.)

There is no disputing that Gundlach has produced great performance.  It is also obvious that is he outspoken and controversial.  A recent webcastDoubleLine Funds | It was recorded on June 9, 2015. provided ample evidence; it contained his always worthwhile commentary on the bond market, along with plenty of remarks that disparaged the views of others (in this instance including a proclamation of the “stupidity” of a common belief — and a thinly-veiled dig at Morningstar, when he said that “the type of CMOs we own get a lot of scrutiny by some weak analysts out there”).

It would be interesting to do a linguistic analysis of the webcast, to see what it says about the man.  It is generally assumed that “key man risk” is high at DoubleLine — if anything happened to Gundlach, investors would flee — and people debate the trade-off between his obvious genius and indications of a potentially volatile personality.  One commenter on the WSJ article called Gundlach “an arrogant man interested in enriching himself,” which another described as “actually high praise and a strong endorsement” when it comes to the evaluation of an investment manager.  In practice, the assessment of personality traits tends to vary with performance; those with good numbers get a pass, while the same characteristics in poor performers are evidence of their unsuitability for the task.

But let’s set that topic aside and think about process.  During the webcast, Gundlach displayed a chart comparing the duration of the fund over time to the yield on ten-year Treasury notes.  “It almost looks like magic,” he said, because the interest-rate sensitivity tended to peak when rates were topping and to bottom in advance of them moving higher.

Assuming it’s something other than magic, how does that happen?  That’s difficult for a manager to convey and almost impossible for investors to comprehend without being inside the organization.  Most declarations about a manager’s “consistent and repeatable process”the research puzzle | You won’t find me using that phrase. are based upon historical performance patterns and savvy marketing.  To our detriment, we see performance and infer process.the research puzzle | That phrase has become a foundational belief of mine regarding due diligence practices.  Here’s where I first used (borrowed) it.

In other words, we don’t see what’s going on behind the curtain.

Thus, we tend to rely on others to tell us what’s happening.  Morningstar is the best known firm in the business of doing that; there are many others performing similar work, including institutional consultantsthe research puzzle | This posting looked at what we ask those consultants to do, and whether they are good at picking winners among managers. and gatekeepers of investment platforms.  But, for the most part, we don’t see behind their curtains either.  For example, it’s hard for us to know whether Morningstar is doing adequate due diligence on the funds it rates (or whether DoubleLine’s specific complaints about it are justifiable).

Morningstar is generally better than others at explaining the basics of how it rates funds and other vehicles, but only the basics.  You don’t learn enough from its reports or methodology papers to know whether its due diligence practices are appropriate in general or in a particular situation, or whether its analysts are up to the task.  (That is true for its competitors as well.)

What do you need to know before you’re willing to invest?  What kind of access do you need to have?  What degree of transparency?  Do you rely upon the evaluations of third parties as a key part of your decision making process?  In what way?

Your answers to those questions will likely vary substantially based upon the kind of organization you work for, the size of the pool of assets being invested, the resources you have available to you, and the strategies and methodologies that you employ.  In the end, though, do you get “enough information to constitute a sound decision”?

That is the question of the day, and it remains unasked far too often.  DoubleLine and Morningstar will continue their battle.  Our job is to decide what we need to know before we use their respective services (or those of other providers) — and what we are willing to let them keep behind the curtain.