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.

Because the investor's experience with a mutual fund will determine how he feels about it much more than the fund's overall performance, new funds try to minimize the bad investor experiences. But no matter what the fund does, an investor can still have a bad experience, Phillips says. "Today, when funds are behaving better than any time since 1986, investors still chase performance."

Phillips has been tracking investor experience with funds and comparing that with the funds' performance. He finds that many investors still make the mistake of pumping money into a fund just as it reaches a peak. Then they ride down with the fund, and finally, when it reaches a trough, they sell in disgust. "The investor doesn't know what the fund did in total returns," he says. "The investor only knows his own experience."

Phillips looked at the 25% of funds with the highest volatility in each category and found that investors in these funds lost nearly 200 basis points to volatility. In the funds with the lowest standard deviation, he found that the investor captured almost all the return. Phillips suggests that an investor look at the "leaders and laggards," where he will find the same funds on one list or the other because high volatility funds either soar or sink, depending on the market environment.

And the exchange-traded fund market? Will it displace mutual funds? Not right now, Phillips says. As mutual funds become more tame, more predictable, more responsible and responsive to shareholders, ETFs will take their place on the wild and woolly frontier. ETFs are doing what mutual funds did in the '90s, he says-using leverage and letting the market decide which ones are good and which are not.

One of the warning signals is how willing fund companies are to follow trends. For example, Phillips points to the Internet fund craze during the tech bubble in the late '90s. As a litmus test, he looked at "Internet funds" and decided that those companies doing a good job for their shareholders weren't offering one.  This list included American, Vanguard, T. Rowe, Fidelity and Dodge & Cox.

Phillips suggests that such trend chasing is characteristic of the ETF world now. "There can only be so many S&P index funds," and so ETFs try quirky products based on a trend and let the market decide which ones work, he says.

Although Phillips likes the idea of ETFs, he thinks the market needs to go through the same learning curve as the mutual fund industry has. When he attends a mutual fund industry conference, he finds the fund industry "very humbled" by its recent woes, including the investigations by Eliot Spitzer, the disgraced former governor and attorney general of New York.

Phillips recalls testifying before the U.S. Congress following testimony by Spitzer, who was then the New York state attorney general. In a brief conversation after the hearing, Phillips says he objected to Spitzer's calling the mutual fund industry "a cesspool," and Spitzer's response: "Don, every rock I turn over, I find more vermin." Spitzer wasn't referring to his private life.

But ETF conferences are quite different from mutual fund gatherings. Here the participants are "very arrogant and talk about throwing product out into the marketplace and letting the market decide what works." However, Phillips, like other mutual fund observers, is intrigued by the new Wisdom Tree ETFs, which he predicts will create a good investor experience. The fund's cost is low-28 to 58 basis points-and the funds are tilted toward value because they invest in high-dividend stocks.

Over time, index funds haven't done any better than managed funds, Phillips says, passing on a quote he heard at a conference that "indexing is a more efficient way to have a bad experience."

So Phillips thinks that mutual funds have responded to criticism, to having the light shone on them-by creating better investment experiences. For example, he says that in the '90s, money management and distribution were under one roof so that leadership came from the marketing side. "We can sell this if you create it!"

Now many companies-like Merrill and Citigroup-are getting out of the fund management business, eliminating in-house rules that made funds a bad experience for shareholders. For example, the wirehouses typically required that brokers keep a majority of investor money in in-house funds. The brokers typically were paid higher commissions and higher ongoing fees for these in-house funds, all things that worked against a good investor experience by giving broker incentives to push mediocre funds.

By contrast, today fund companies are setting up "gatekeepers" to do due diligence on funds that will be offered and choosing those that can create a good investor experience rather than those that create a good salesman experience by offering brokers a higher payout. "In a real sense we have won," Phillips says. "Assets now flow to the best fund rather than the best marketing."

After praising Phillips and admitting that I am a fan, I must mention all the e-mail I got on a recent column (Financial Advisor, April 2008) from readers who felt I was promoting Northwestern Mutual Life. That was certainly not my intent, and I'll come back to clarify that in next month's column.

Mary Rowland can be reached at [email protected]. She has been a business and personal finance journalist for 30 years and has written two books for financial advisors: Best Practices and In Search of the Perfect Model.