When I was in Chicago on business last week, I thought to stop in to say hello to Don Phillips, managing director of Morningstar, and to catch up with what's happening in mutual funds. I've known Don since he started at Morningstar with Joe Mansueto back in 1986.

Don's always been a great information source, surely on mutual funds but on lots of other things, too. Because he's so candid. And such an optimist. Almost a Boy Scout, really. And one of my favorite people. Don always looks for the best in mutual funds, and when funds are behaving badly, he believes that good will prevail in the end and he starts to push toward the "right" side, right being what is best for shareholders. Phillips quotes Martin Luther King: "The moral arc of the universe is long, but eventually it tilts toward justice."

It's worth reminiscing about how Morningstar and independent financial advisors changed the investing landscape to the point where Phillips says that few-if any-of the wirehouses are pushing in-house funds anymore. Most of them are trying to duplicate the RIA model, Phillips says.

I met Phillips at his office in early May and he pulled out a list of the top mutual fund firms on December 31, 1986, when he came into the business.
Phillips remembers that, back then, people said: "Mutual funds are sold, not bought." Not surprisingly, the shops on this list are predominantly load shops, he says. Many funds were overpriced and badly managed, and the fund companies aimed to be outstanding marketers rather than outstanding managers. Funds were sold with a glitzy promise and enticing names like The Technology Fund or Global Technology.

But in some ways, most funds of the late 1980s were alike: expensive, unfocused-ready to follow the hot money, to leverage and to take on more and more risk to chase return. Phillips remembers the Franklin U.S. Government Bond Fund with a 4% load on investments-and on reinvested dividends as well. Another fund, Alliance North American Government, had a patriotic ring to its name, but it emphasized Mexico, Phillips says. And 38% of the fund was invested in Argentina.

The mindset in the '90s was: build it and sell it, Phillips says. They thought, "We have this big sales force, so we can pump out mediocrity and the sales force will sell it." The fund companies with the most marketing muscle did well.

Back then, we were asking each other: "Who's going to win, load or no-load? Passive or active?" Phillips remembers. "But it didn't play out that way. The funds that won were the ones that gave consumers a good investing experience like Vanguard, like the American Funds."
Now many of the shops on the top funds list from 1986 "are trying to create the model of registered investment advisory firms," Phillips says. "The game has changed."

Phillips credits John Bogle, founder of Vanguard, with pointing out the difference between salesmanship and stewardship. Morningstar now grades 5,000 funds based on stewardship-studying each fund's incentive structure, its bonuses, how much directors invest in it as well as other indications that the fund's management is aligned with shareholder interest. When Morningstar began grading funds, not even 50% of fund directors had an amount invested in the portfolios they ran that was equal to one year's compensation.

Each fund is given a grade from A to F, and Phillips made a correlation between asset flows and stewardship grades. The funds graded D and F experienced net redemptions, he says. Funds with a grade of C held a steady amount of assets and those with grades of B and A were attracting large asset flows. Since Morningstar began to publish the stewardship grade, some funds have called to say that their directors have invested more in the funds.    

One fund company official asked: "If we send you the paperwork proving that a director has invested more, will you change our grade?" Phillips says, "When you shine a light on something, everything changes." That's what Morningstar and independent financial advisors have done with the mutual fund industry.