Since launching his own firm early in 2010, DoubleLine CEO Jeffrey Gundlach has taken the mutual fund industry by storm. His flagship fund, the DoubleLine Total Return Fund, and his company quickly became the respective fastest-growing mutual fund and fund company in history.
In the process, Gundlach has cultivated the image of a brilliant but coldly realistic student of financial markets prone to making bold, headline-grabbing predictions. The math wizard has marketed DoubleLine funds relying on his superb public speaking skills sprinkled with bombastic remarks. Often, he leaves audiences spellbound with his ability to discern the almost perfect negative correlations between such seemingly unrelated asset classes as gold and U.S. housing since 2010.
For the better part of two decades, Gundlach managed fixed-income assets for Trust Company of the West (TCW) in relative obscurity. Within fixed-income circles, he was admired as one of the world’s smartest managers of mortgage-backed securities (MBS). At TCW, he worked with Howard Marks, the world’s leading distressed debt investor, who left in 1996 to start Oaktree, which now owns about 20% of DoubleLine. Both firms are based in Los Angeles and some believe Oaktree may eventually buy a controlling interest in DoubleLine.
Gundlach turned in great numbers during the market meltdown of 2007-2008 after making a name for himself with his 15 years running the TCW Total Return Bond fund. He recorded a 7.2% return over that two-year period, according to Morningstar, which gave him their fixed-income manager of the year title in 2006. In 2009, the fund climbed 19.5%, most of that gain achieved before TCW fired Gundlach in early December. That meant he beat almost everyone else managing intermediate-term bond funds.
In short, Gundlach cleaned up while other portfolios were blowing up during the housing nightmare. But he never enjoyed the high profile of managers who pen provocative commentaries like Marks, Pimco’s Bill Gross and GMO’s Jeremy Grantham. All that changed in 2010 with the launch of DoubleLine. Further enhancing his visibility was the nasty legal battle that ensued in 2010 between DoubleLine and TCW, which accused him of theft of trade secrets. In the end, TCW’s lawsuit was an embarrassing failure. TCW lost and was forced to pay him a $67 million bonus it had withheld for one quarter’s worth of performance fees for a hedge fund he had managed.
Some say the reason for Gundlach’s departure was that TCW and its parent, France’s Société Générale, sought to avoid paying him potentially billions in performance fees on the hedge fund, as it became apparent the depressed mortgage-related securities purchased at fire-sale prices during the financial crisis were going to pay off. Others say he was fired because TCW got wind of reports he was looking to leave and start his own firm. Whatever happened, both parties no doubt would agree they had developed irreconcilable differences.
Within hours of TCW’s announcement that it had fired Gundlach and replaced him with a team of fixed-income professionals from crosstown rival Metropolitan West, Morningstar’s director of fixed-income research, Eric Jacobson, issued a report calling it a “savvy” move on the part of TCW. The timing of the report became the first in a series of comments and suggestions by Morningstar that incensed DoubleLine personnel, who believed that Jacobson was informed of TCW’s decision to fire Gundlach well ahead of time. Morningstar maintains it was referring to TCW’s decision to acquire MetWest as “savvy” because it might stem the likely flow of assets in the wake of Gundlach’s exit.
As Gundlach and his team were launching their new firm, they came to believe that Morningstar deviated far beyond any bounds of impartiality during the TCW lawsuit for reasons they still can’t understand. They note that, in the middle of the lawsuit, Morningstar mentioned that DoubleLine might be under a federal criminal investigation. The fund rater would later say it misinterpreted a DoubleLine filing.
Last year, Morningstar gave five-star ratings to the DoubleLine Total Return fund and the DoubleLine Core Fixed-Income Fund, which came up for their three-year reviews, accompanied by a neutral analyst rating. Still, after a 2011 report entitled “Swim At Your Own Risk,” DoubleLine ended communication with Morningstar.com analysts.
Executives at DoubleLine don’t think Morningstar.com analysts had an ulterior motive for playing favorites when Gundlach was pushed out of TCW, uncharacteristically siding with a large, established asset manager over a young startup. But like other financial analysts and asset managers, once they took a position, they dug themselves in. Beyond the TCW lawsuit, DoubleLine officials say the problem isn’t their funds. It is that open-end Morningstar.com analysts act as commentators, offering opinions while failing to understand complex debt securities like inverse floaters and other unique vehicles. DoubleLine officials quickly add that the analysts in Morningstar’s institutional research group, many of whom are CFAs, are professionals whom they respect.
A Morningstar spokeswoman says her company has been a longtime admirer of Gundlach, adding that he had been given center stage at Morningstar conferences several times. Both Gundlach and Morningstar executives also have been speakers at Financial Advisor conferences.
Gundlach “currently gets our highest marks for both people and performance in our analyst rating system,” says Morningstar’s director of media relations, Nadine Youssef. “If you read what we’ve published on Gundlach over the years, you’ll find extensive praise for his abilities. A neutral rating on his fund is hardly a stinging indictment. It’s simply our analyst’s current opinion, especially given the lack of information from DoubleLine.”
The feud disguises a larger question surrounding DoubleLine and all its competitors. As the bond market begins what many believe will be a glacial-age bear market, how risky are all these funds and how are they reaching for returns in a stingy bond market. In a recent report, Morningstar still refers to Gundlach as “a mortgage maven,” a manager with “a stellar record” at his previous job running the TCW Total Return Bond fund.
But Morningstar has also maintained it was unsure of the riskiness of Gundlach’s approach, implying that he took more risks at DoubleLine than he ever did at TCW. In fact, Gundlach’s returns in his final three years at TCW varied widely from 6.2% in 2007 to 0.9% in 2008 to 19.5% in 2009. All of these years were abnormal years for the bond market, but defining a normal year for bonds in the last decade is like proving the existence of infinity.
Morningstar acknowledges that DoubleLine’s returns in 2010 and 2011 were outstanding but attributes part of their success to substantial stakes in exotic MBS, including interest-only, inverse-interest and inverse floaters. It argues the positions were large compared to previous positions Gundlach held at TCW Total Return and those held by competitors. Those positions have been reduced in the last two years.
Many other managers, however, also have been using derivatives and exotic securities as they search for yield in the recent low-interest-rate world. In January 2013, Pimco’s Bill Gross was asked in the annual Barron’s Roundtable about his use of derivatives to generate a double-digit return for his recently launched BOND ETF, a real-time proxy for his giant Total Return Bond Fund. Gross candidly responded by challenging anyone to produce similar returns without using derivatives.
Morningstar’s view that it’s difficult to measure the fund’s riskiness is worth closer examination. Through December 31, 2013, DoubleLine Total Return’s institutional investor shares (where the majority of its assets reside) returned 8.38% since its launch in May 2010 while the Barclays U.S. Aggregate Bond Index returned only 3.66%, according to Zephyr StyleADVISOR data. The average intermediate bond fund in Morningstar’s universe returned 4.06%. Comparing the fund to indexes via their Sharpe ratio, a risk-adjusted return measure, the DoubleLine Total Return Fund sports a Sharpe metric of 2.70 compared to 1.27 for the Barclays index and 1.41 for the Morningstar intermediate bond universe.
How valid is Morningstar’s claim that the fund has earned those outsized returns in its first two years by walking a tightrope? The evidence is that the Total Return fund displayed slightly more volatility in 2010, when its standard deviation was 3.04% versus 2.62% for the Barclays Aggregate and 2.53% for the Morningstar universe. In 2011, however, DoubleLine’s standard deviation was virtually identical to the Barclays Aggregate (2.36% versus 2.35%) and slightly less than the Morningstar universe’s at 2.43%.
That is hardly a red flag. In 2012, DoubleLine’s flagship fund returned 9.16% in contrast to 4.21% for the Barclays index and 6.85% for the Morningstar intermediate world. This time, its Sharpe ratio of 5.80 easily topped Barclays’ (2.06) and Morningstar’s universe (3.59). In 2013, DoubleLine Total Return showed it doesn’t walk on water, as it barely eked out a positive 0.02% return, which still placed it in the top 87% of all funds in the category. Barclays’ index fell 2.02%, while Morningstar’s universe was off 1.38%. On the standard deviation and Sharpe ratio risk metrics, DoubleLine’s numbers were slightly better than the averages.
Morningstar continues to voice concern that a sudden interest rate spike could make that tightrope very precarious since instruments like inverse floaters can become vulnerable to illiquidity and the unpredictable behavior of investors in market sell-offs. “These positions were very large compared to both what [Gundlach] had held in the past at TCW Total Return and the size of positions held by competitor portfolios,” says Sarah Bush, a Morningstar analyst. “
Who Changed Their Tune?
Bush’s assessment is contradicted by comments Jacobson made on October 8, 2009 in a Fund Spy column, previewing Gundlach’s nomination as Morningstar’s bond fund manager of the year only two months before TCW fired him. “Gundlach has always stuck almost exclusively with government-backed mortgages, if not the simplest variety, so the fund had some protection from the credit driven bear market,” Jacobson wrote. “What’s arguably even more impressive is how he’s managed to produce a peer-beating 19% rebound thus far in 2009, after pumping the portfolio with nearly 46% in beaten-down non-agency mortgages at one point in 2008.” It is difficult to believe these non-agency mortgages carried less risk when TCW held them in 2008 and 2009 than when DoubleLine did in 2010 and 2011.
Gundlach finds the Morningstar evaluation puzzling. He says the fund “outperformed its benchmark, outperformed its Morningstar intermediate-term bond fund peer group and exhibited lower volatility than its benchmark.”
In a Q&A with Financial Advisor magazine last fall, he says the fund is prepared even if all MBS funds try exiting the cash doors at the same time. Sudden spikes in interest rates represent the greatest threat facing the market, he argues. He questions whether Morningstar officials really understand the DoubleLine MBS portfolio and finds Morningstar’s risk warnings difficult to understand.
“Morningstar.com’s assessment of potential liquidity challenges for DBLTX is perplexing given that cash represents over 10% of the fund’s holdings and very high-liquidity government guaranteed MBS pass-throughs represent another 30%,” Gundlach said last fall. He added that his portfolio is primed for the interest rate and prepayment risks in mortgage-based securities. “Bonds are less risky than they were a few months ago because the yield is now quite a bit higher (thus, more attractive) while inflation does not appear to be worsening,” he says. He maintains his portfolio has sound risk controls.
For instance, Gundlach argues that inverse floaters backed by government guaranteed mortgages have no risk other than interest rate risk and prepayment risk. These risks are shared with all government guaranteed bonds. “Inverse floaters can have a high level of interest rate risk, similar to long-term U.S. Treasurys,” Gundlach says. “A portfolio of nothing but inverse floaters would have high volatility, similar to that of a portfolio of nothing but long-term U.S. Treasurys. A portfolio with a fraction invested in inverse floaters can easily have overall interest and prepayment risk well below that of a Total Bond Market Index fund.”
Gundlach maintains the way the bond market played out last year reveals that Morningstar’s concerns are misplaced. “The open-end mutual fund raters at Morningstar.com framed this ‘concern’ as a forward-looking hypothetical,” he notes. “We now have empirical evidence of the inaccuracy of their assessment. In 2013, we have seen interest rates rise sharply over a relatively short time period and bond funds experience outflows. DBLTX in 2013 has (1) outperformed its benchmark, (2) outperformed its Morningstar intermediate-term bond fund peer group, (3) exhibited lower volatility than its benchmark, (4) exhibited lower volatility than its peer group, (5) exhibited a lower drawdown than its benchmark, (6) exhibited a lower drawdown than most members of the peer group.”
He believes that the Federal Reserve is unlikely to raise rates in the short term. That is a sentiment that was recently confirmed by the Fed’s announcement that it would continue easy money policies—despite other recent hints that it might do the opposite.
In its review last summer, Morningstar conceded that DoubleLine continues to be “tops” in its category and had somewhat reduced its use of “esoteric mortgage-backed securities, including inverse-in-interest-only and inverse floating-rate bonds.” Gundlach himself told clients in a recent Webcast on December 10 that esoteric securities now represent less than 2.5% of his fund’s portfolios.
But Morningstar officials vigorously defend their neutral rating. They say their reading is a qualitative assessment that focuses on five factors: a fund’s people, its parent company, its performance, process and price. “Our analysts not only look at risk-adjusted returns, but also conduct manager interviews, research filings, and observe multiple data points and metrics,” says Youssef. She adds that DoubleLine officials’ refusal to speak to Morningstar hurts its efforts.
Other analysts take sharp issue with Morningstar. Jeremy DeGroot, CIO of Litman Gregory Asset Management, conducted extensive research on Gundlach before naming him as sub-advisor of a sleeve for the firm’s Masters Alternative Strategies fund.
“We don’t share Morningstar’s view. We disagree,” he says. DeGroot acknowledges that when one observes Gundlach in public and listens to his pronouncements on hot stocks ranging from Apple and Chipotle to the Spanish stock market index, they could easily suspect him of being a risk-loving high roller.
But the reality is he possesses “a very long record of assessing, managing and offsetting risk,” DeGroot says. “He has an ability to control risk and synthesize a complex, multi-variable group of markets.”
The sleeve of the Masters Alternative fund that Gundlach manages represents his “best ideas” and DeGroot claims its holdings might look more like those of his private hedge fund than the securities in DoubleLine funds. “This strategy is higher risk [than DoubleLine’s other mutual funds] but he isn’t swinging for the fences,” DeGroot argues. “He will not own a bond if he thinks there is a chance it will default.”
Jeff Tjornehoj, a senior analyst at Lipper, acknowledges that the MBS market possesses risks. After all, it was the epicenter of the 2008 financial crisis, which triggered the worst recession in 80 years. But Tjornehoj believes DoubleLine’s risk controls are superior to most rivals. “We looked at the last period when volatility spiked in the bond market [and] the volatility in his fund spiked much less that its average peers,” he said.
Outside of DoubleLine, others have accused Morningstar of selective bias. Bond fund manager and Internet columnist David Schawel noted that top hedge-fund managers like Seth Klarman, Kyle Bass and Daniel Loeb were also heavily invested in non-agency MBS at the same time as Gundlach. In a 2011 column on Economic Musings, he challenged Morningstar’s analysis and questioned its objectivity. “The beauty of the DoubleLine managed funds is that the team isn’t trying to guess interest rates,” Schawel wrote. “They have clearly devised a strategy that takes advantage of extreme dislocation in the RMBS market and paired them against longer duration agency securities that perform well, stay flat or move lower.”
In May 2013, John Coumarianos, an RIA, independent blogger and former Morningstar analyst, doubted in a blog if “Morningstar analysts are equipped to judge how Gundlach and his team evaluate complex mortgage securities. The bond market is ‘The Wild West’ of the investment world, as Michael Lewis has written, and it’s not easy for even very bright people to make sense of it (especially the mortgage market).”
What Coumarianos finds “troublesome is that some of the finest equity managers Morningstar covers—and gives strong qualitative assessments to—dabble in distressed debt when they think prices warrant it.” Topflight equity managers like Steve Romick at FPA Crescent and teams at Mutual Series and Third Avenue Value have won “kudos [from Morningstar] for going the extra mile in uncovering underpriced oddball securities,” he wrote.
How does Gundlach himself evaluate the riskiness of his funds? Asked during last December’s Webcast, why not buy an index fund, Gundlach thanked the questioner for throwing him “a softball” and noted that the strategy followed by the Total Return Fund for two decades since his TCW days outperformed its benchmark 70% of the time. Significantly, he said it performed particularly well in bear markets. He quickly added that the company Core Fixed-Income was riskier and should provide higher returns over a full market cycle, though that has yet to happen.
Since DoubleLine opened its doors, the fund manager has entered the equity markets and formed numerous joint ventures managing sleeves of various multi-sector funds with Litman Gregory, Aston, RiverNorth and most recently Nobel laureate Robert Shiller. If DoubleLine’s flagship’s fund record and style consistency going back to TCW days are as continuous as they appear, then analysts looking for risk in its funds might find more fertile territory in new ventures where its track record is scant.
Since it was started in 1984, Morningstar has earned a reputation for fairness, objectivity and integrity that would be the envy of other financial rating firms, most notably the bond raters. When its star rating system was challenged in the early 1990s, it hired leading academics, including Nobel laureate William Sharpe, to conduct a review. If the feud turns out to be simply another case of a few analysts taking a strong position and refusing to waver, it would appear very unusual for Morningstar but normal for the rest of the financial services business.