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Investing Specialists

John Rekenthaler: Fund Manager Financial Incentives Are Irrelevant

Morningstar's columnist reflects on his decades of analyzing and writing about the mutual fund, retirement, and financial advice industries.

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Our guest this week is John Rekenthaler. Rekenthaler is a director in Morningstar Research Services and a feature contributor to our platforms, including Morningstar.com. A lucid thinker and brilliant writer, his popular "Rekenthaler Report" column has become a must read among investors, financial advisors, fund industry participants, and beyond.

Rekenthaler began his career at Morningstar in 1988 and has worn a number of hats, including leadership roles in our research and investment management divisions. Among other achievements, Rekenthaler has been a key player in developing some of Morningstar's best-known tools, including the Morningstar Rating for funds and the Morningstar Style Box. He holds a bachelor's degree in English from the University of Pennsylvania and a master's degree in business administration from the University of Chicago Graduate School of Business.

Background
The Rekenthaler Report

Morningstar Rating for funds methodology

Morningstar Style Box methodology

Investor Behavior 
Morningstar's Mind the Gap study

Rekenthaler Report: "Mutual Funds: Where Fun Came to Die"

Rekenthaler Report: "3 Reasons Index Investors Deserve Perdition (or Not)"

Rekenthaler Report: "Up-Front Investment Fees Are (Almost) No More"

Incentives
Rekenthaler Report: "Give Performance Fees a Chance"

How Rekenthaler Invests
Rekenthaler Report: "What's in My Portfolio?"

Most and Least Popular Columns
Rekenthaler Report: "Enough with Revenue Sharing!"

Rekenthaler Report: "About that Rigging Claim"

Flash Boys: A Wall Street Revolt, by Michael Lewis, March 2014.

Compelling Academic Research
Rekenthaler Report: "Predicting Mutual Fund Returns With the Ownership Lens"

"Judging Fund Managers by the Company They Keep," by Randolph Cohen, Joshua Coval, and Lubos Pastor; NBER Working Paper No. 9359, December 2002.

The State of Retirement
Rekenthaler Report: "The Retirement Crisis That Isn't?"

Teresa Ghilarducci

"A Perplexing Tale About 401(k)s," by Scott Cooley; Morningstar.com, Nov. 26, 2015.

Rekenthaler Report: "The British Show How to Improve 401(k)s"

Best and Worst Innovations
Rekenthaler Report: "Why ETFs Succeeded for Retail Investors"

Rekenthaler Report: "Tactical-Allocation Funds: Even Worse Than Expected"

Jack Bogle
Rekenthaler Report: "Jack Bogle Strikes Back!"

Rekenthaler Report: "Jack Bogle's (Somewhat) Accidental Legacy"

Corporate Governance
"Anticompetitive Effects of Common Ownership," by Jose Azar, Martin Schmalz, and Isabel Tecu; Journal of Finance, May 2018.

Rekenthaler Report: "Are Index Funds Too Soft on CEOs?"

Rekenthaler Report: "The Latest Salvo Against Indexing"

Rekenthaler Report: "The Doctrine of Shareholder Value Has Indeed Helped Shareholders"

Albert J. "Chainsaw Al" Dunlap bio

What Rekenthaler Reads
Berkshire Hathaway shareholder letters

Joe Mansueto bio

Reflections on Investing
Rekenthaler Report: "My Investment Howler"

Transcript

Jeff Ptak: Hi and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.

Ptak: Our guest this week is John Rekenthaler. John is a director in Morningstar Research Services and a feature contributor to our platforms including Morningstar.com. A lucid thinker and brilliant writer, John's popular Rekenthaler Report column has become a must-read among investors, financial advisors, fund-industry participants, and beyond.

John began his career at Morningstar in 1988, and has worn a number of hats, including leadership roles in our Research and Investment Management divisions. Among other achievements, John has been a key player in developing some of Morningstar's best-known tools, including the Morningstar Star Rating for funds and the Morningstar Style Box. He holds a bachelor's degree in English from the University of Pennsylvania and a master's degree in business administration from the University of Chicago Graduate School of Business.

John, welcome to The Long View.

John Rekenthaler: Thank you. Good to be here.

Ptak: So, maybe we'll start things off on a reflective note. You've written about mutual funds and investing, dealt with investors, readers for many, many years now. And I'm sure that it's imparted certain lessons. But I guess a logical place to start is asking whether you come to any conclusions about whether fund investors are smart or not, and whether your perception of fund-investor behavior and aptitude has changed through the years based on sort of the lessons that you've learned in interacting with your audience, your readership?

Rekenthaler: Well, I don't think there's any question that fund investors are making better decisions now than they were when I started at Morningstar in 1988. When I began at Morningstar, the largest outside of Fidelity Magellan, which legitimately was popular because it had a fantastic track record and history of success, the largest mutual funds were funds called government-plus bond funds. Government-plus bond funds don't exist any longer, which tells you how good they were. These were the largest funds in the world and they're extinct. They were dinosaurs. And I won't go into there. But the bottom line was, you paid 1.5%, 2% for a government bond fund that was pulling tricks with options and it was a complicated strategy that sold at a high price. And people bought into them not knowing what they were getting largely. And therefore, they redeemed fairly quickly when they were surprised. That's not a good fund experience.

You don't see that happening today, these days. The vast majority of assets are in low-cost, plain-vanilla, straightforward funds, and people know what they're getting. So, I think the investor understanding is much more aligned with what the mutual funds and ETFs--I should say ETFs because they've become monstrous and they weren't around when I started--are much more aligned than they were in the past.

Ptak: And so, to what would you attribute those improvements? Obviously, investors are a more educated lot. They have more information at their disposal. But are there other factors that you think have helped them to succeed?

Rekenthaler: Oh, clearly my work at Morningstar. No, I mean, it's just been a collective learning process. At Morningstar, we had our own learning to do. I was a lot more generous to these funds at the beginning than I would be now. I was less conscious of the effect of fees, most people were more ready to believe stories, tales, portfolio managers, having insights that somehow other portfolio managers didn't have and so forth. So, we've all learned. When I started at Morningstar, The Wall Street Journal didn't have anybody full time on a funds beat; they had one half-time, part-time reporter. So, the media coverage has greatly increased. We have 30 more years of experience and an Internet technology where you can call up numbers and there's just a tremendous amount of more of information and experiences out there. So, it's led people by and large to make more-logical decisions.

Benz: What about the idea--you sometimes hear people say, "Well, the retail-fund investors, those are the real dumb bunnies, whereas the advisors and institutional investors are making smarter choices." Do the data support that when you've looked at that in the past?

Rekenthaler: That's been a common theme of mine to look into those claims. I mean, part of my role at Morningstar has been, people say things, are they true or not? By and large, that's not been true. I mean, it was a little hard to argue with the dumb bunny argument, say, with those government-plus funds, although they were more dumb victims because those funds were entirely advisor-sold. So, really, you could say, well, the advisors selling those funds, they were the ones putting those clients--and there were no government-plus funds that were direct no-load funds that were direct marketed; the direct investor didn't buy those. But for the most part, no, that's not true.

I just did a--in fact, I just looked recently at the overall asset allocation that are in mutual funds and ETFs. So, it's not any one individual investor's allocation. But the aggregate asset allocation is very similar to that of state pension funds, except for the percentage in equities is the same and then the giant state pension funds have more in alternatives as opposed to a kind of plain-vanilla bond in cash, which hasn't necessarily helped them either. So, these things get said without being tested. It's amazing for such a huge industry that we have, how many things get said and taken as being true without ever being tested.

For example, in the late 1990s, all these new 401(k) investors are going to panic when a big bear market starts and they're going to exacerbate the bear market. Yes, well, we did have a very bad bear market from 2000 to 2002. But ironically, the 401(k) assets were almost the very stickiest of assets. They were lower redeeming than other segments of the mutual fund industry. And institutions also had their share of redemptions aside from that. So, it generally has not been true.

Ptak: They say the same thing in certain quarters about index funds, right, that they'll have an amplifying effect if we do have a bear market and all this dumb money will pour out and it will create these wider amplitudes in the market.

Rekenthaler: Yeah, the index-fund panic argument is just a 20-year rehash of the newbie 401(k)-investor argument and it's just about as likely to be accurate as that one was.

Ptak: You know, I wanted to return to 401(k) …

Rekenthaler: It's untested and said by people who either haven't completely fully thought through the issues or, in many cases, are trying to sell something.

Ptak: Yeah, they have an agenda. Sure.

Rekenthaler: Yes, they do.

Ptak: I wanted to go back to 401(k)s. One of the things that succeeded is auto-enroll, defaulting people into funds, ensuring essentially that the fund does everything for them, right? Maybe it's a target-date fund. And so, the asset allocation is set, the glide path is set, the rebalancing frequency is set. They don't really have to do anything. And so, the question is, is choice overrated in a sense?

Rekenthaler: Well, that's certainly been the learning that we've had within 401(k) plans. And believe me, I, as much as anybody, have adjusted my thinking on this. I wrote an editorial in the late 1990s about brokerage accounts--the brokerage windows being in 401(k)s and how these were inevitable, they're coming, it's a good thing to give people, investors more choice. The idea that the bigger the possible menu, the more choice--how could that be bad? Well, we've learned, and the behavioral research has shown us, a lot of these changes come from the academic community. The 401(k) marketplace has been one of the places most affected by academic research, showing that when you give people more choices, they often freeze, they make just random bad decisions like--because they can't process all that information--like just buy a little bit of all these things or some at the top of the page or whatever. So, in this case, restricting choice but not eliminating it because people can always opt out. It's important within every 401(k) system, there are always opt-out provisions. These are leading to better outcomes. We have higher participation rates and we're in better diversified portfolios. Today's 401(k) bands are better than they were 20 years ago.

Ptak: So, what's your take then on the trend toward personalization? There are some who talk about that as if maybe that's the new wave: If active is out, personalization is in. In a sense, personalization represents making additional choices, right? It's who I am, right? And I'm going to decide who I am and make these different choices. And basically, you, my representative, is going to build something in my image, right? And so, do you think that's counterproductive in the sense that we have investors that are making more rather than fewer choices in the name of personalizing?

Rekenthaler: Well, if personalization is going to occur, I think it will occur through financial advisors, through professional assistance, through something where the process for the investor isn't painful because they're talking about themselves. Or, they feel that somehow they are working with a professional who is going to make them better. If you ask people to personalize and give you additional information, say, on a website or something like that, very few people are willing to do that. Morningstar, along with other companies, used to be in the business of putting out calculators and investment-advice programs that you could ask people to put in supplemental information like the other portfolio holdings, and you do amazing personally--we customized portfolios, adjusting on the investment style of what they already had, and all sorts of things. And very few people are willing to do that. And I could go on at length, which I will not, about companies, other companies that came to the marketplace with technological personalization services, and they're not successful. And the ones that are really selling mass product, like an index fund that's the same for everybody, are successful. I do think that this can be something that can supplement or help to modify advisors' practices, but I don't see it as being delivered successfully to the direct investor. The direct investor wants something simpler. Most people are just not investment junkies.

Benz: One thing I obsess over, and I get pushback on the idea of simplifying retirement decumulation, like that process of actually extracting money from your in-retirement portfolio. A question I have is, do you think that can be simplified somehow through technology or through some sort of solution? Advisors say no, that it needs to be like this highly customized approach. And I get that, but what's your take on that question?

Rekenthaler: I think that it can be simplified. I'm glad it's not my job to try figure out how to deliver that. And the fact that it's a difficult task, you know, it could be witnessed by the fact that there aren't programs out there or somebody successfully hasn't taken a mass-simplification solution to the marketplace. I don't think that doesn't mean it can't happen. Generally speaking, we've seen people say--advisors tend to say it's more complicated than that, because that's their life and I understand that. And I'm not denying that they can't do things for their clients that one cannot get through a mass solution, because that's true, particularly as clients' lives gets more complicated. But a lot of things that they said, well, you can't do, yeah, you could end up doing.

And early on, the academics, actually--I mean, these are the people you think are most into complexity. The academics were saying, "You know what, you can do something like a target-date fund. You can make an assumption that all 2045 retirees are the same. It's close enough to the truth. Don't let the perfect get in the way of the good. Just go do it. It's better than having people not participate." And they were right. So, that tends to be my view is, if you get something that gets somebody 80% or 90% there, that's a lot better than them not doing something at all.

Ptak: I wanted to ask you about frictions in an investing context. And I guess sort of like a straightforward way to get at that question is, front-loads, right, which are an increasingly endangered species. Some would say, that's a welcome development in the fund world. But I suppose there's an argument to be made. And I think in the past, you've made it that that frictions can actually be a helpful thing to help an investor stick with it or just create some trade-offs that maybe they ought to have to fend with before they make an impulsive choice. Do you think some of those frictions, that too many of those have fallen away and that investors would be better off if there were more formidable switching costs that they faced?

Rekenthaler: I like to think of myself as the world's only investment writer, a mutual fund writer that defends front-end loads besides advisors, because I have defended front-end loads in the past, not as much from the perspective of friction but actually from cost. Because once you get in and you pay that heavy load up front, if you own that fund for a long, long time, it's going to be cheaper than paying ongoing fees, whether it's ongoing 12b-1 fees through a fund or an advisory fee. And I get emails from old-school advisors and believers saying, "I've had my client in this fund since 1974. They paid once. Here's their result now." And of course, you know, in that if you owned an equity fund since 1974. So, that is a positive effect of friction: The fact that once you paid this load, you're reluctant often to go pay another load, and you want to keep it in there.

But what we really see with these frictionless fee-based programs is, advisors feeling the need to justify their decision, because when you sell a fund once, you're paid well when you sold that fund with the front-end load. As an advisor, maybe you don't need to touch that money again. But when you're collecting an annual fee--and you know, I think the advisors, they're in a tough spot. They may think the right thing to do this year is not to make a trade. My own portfolio, I didn't make a trade last year. Let me think for the client. But that can be tough. Advisors are gradually getting more and more away from defining themselves as solely investment managers. And the stronger ones are as financial counselors in general. And the more that they can do that, the better they are positioned, the better for their clients. They don't have to get into this discussion so much.

Benz: You referenced that piece about front-end loads as being unpopular among some advisors. What's the least popular, least well-received piece that you've ever written? Where'd you get the most hate mail?

Rekenthaler: Well, I think, probably, it was my article I wrote several years back on criticizing the idea of performance fees and financial incentives and manager compensation being important. My take was--and a lot of parties, Morningstar included, pay a lot of attention to how managers are compensated. But I don't think that putting more carrots in front of--financial carrots--in front of portfolio managers makes them do a better job. I think they have a tremendous number of reasons already why they would want to do a great job. I mean, the main one being, if they beat their peers and beat their benchmark over a few years, they're going to get massive amounts of assets and massively higher pay, because they're going to be running a bigger fund.

And also, just the competitive spirit. These are competitive people. None of us like to go and be in competition, especially, you know, I don't have my numbers posted daily, monthly, weekly, and companies like Morningstar monitor me. I'd sure as heck to want to get those numbers up. I wouldn't want to go home, trailing somebody else. You know, we see people compete, and put hours and hours of work in. If they're not paid at all for free just on hobbies, in competitions, in fantasy sports leagues with their friends. So, I don't think that it's that important, or even really important at all, how the portfolio managers are paid as long as it's a fairly long-term outlook. I can see if somehow you're doing quarterly bonuses and so forth, you could really start to motivate people to have the long time frame. But as long as the time frame is right--whether the manager has paid a flat salary and almost no bonus or low salary and high bonus--I don't care.

Ptak: So, do you think the alignment of those other incentives, let's say, it's having skin in the game, right? You own shares alongside your shareholders in a mutual fund. Is it that you think it's counterproductive or just we tend to overrate it?

Rekenthaler: I don't think it's counterproductive. I just don't think it matters. I think it's more immaterial or slightly material. I didn't mention owning shares, but I put that in the same camp.

If I have shares of my fund, and my fund makes 10%, and I make 10% on that money that year, that's not as good as 12. But 200 basis points on my investment is probably not my whole life--and even if it is 200 basis points--12 versus 10 makes up a huge amount of difference over a few years for how big my fund is going to be. My pay could be 5 times higher, 10 times higher. It's going to be much more important than that 2% difference.

Ptak: And so, who did the pushback from that piece come from? What was it founded on?

Benz: You maybe, Jeff, right?

Ptak: Yes, apart from analysts that were protesting your view.

Rekenthaler: There was a Morningstar high executive who disagreed with that. But besides him, no, I got a few emails from various people, some individual investors, a couple of advisors, a couple of fund company executives. A lot of people have bought into this idea. It's a common belief, particularly in U.S. business, that money motivates behavior. And if you play better, you get paid more. And those two things are aligned. And it's taught in business schools, performance incentives. We see it in the sales compensation, all across. It's ingrained in our culture, this belief. And it certainly can apply. This is not a blanket statement. I just think in the case of portfolio managers, it's not a blanket rule. And portfolio managers have other reasons and other incentives that will drive them.

Look, how many portfolio managers are out there in the mutual fund business over the years consistently have been beating the indexes? Whatever the incentives are, it's clearly a very tough task. And I don't know if you know whether giving the horse more carrots or taking a stick to his behind, I'm not sure either one of those are really going to change the behavior.

Ptak: It's a really daunting task to try and take a manager's measure. That's something that we try to do professionally every single day. And so, maybe reflecting on the experience that you've had as an analyst and a commentator, if you had to give some advice to somebody that was trying to do that very thing, how would you advise them? What would you tell them is the most important thing to look at, knowing that almost to a person these are going to be very smart, well-credentialed people who are very competitive and type A. What are the things beyond that should they be looking for in a manager?

Rekenthaler: I try to look, when I'm looking at an active fund, the first thing I'm asking myself is, what bets has it made, regardless of whether he's been successful or not. But what environment will help this fund? What environment will this fund look its best, and what environment will make this fund look its worse, and then evaluate the numbers in that light. So, in other words, if I were to look at a fund and say, you know, it's been absolutely a terrible five-year period in relative performance for this fund, because relative to its peers, you know, it's ongoing, it's overweighted in international stocks compared to U.S. stocks, which have done better and in value, rather than growth when it's done better. But you know, it's been in the middle of its pack, despite running into these tailwinds. I'm trying to assess headwinds and tailwinds. And I guess, you would say, we position the fund's numbers based on that.

For me, that's more valuable than discussion with a portfolio manager. Not that that wouldn't be a part of it, or at least reading what other Morningstar researchers have gotten from it, but I find interviews and discussions, certain pointed questions are helpful. But I find the whole task of, judge somebody's character or skill set by talking to them to be difficult. I've done a lot of that in the past. That was my, much of my early job at Morningstar. And sometimes, I got it right. But I'd be fooling myself if I didn't sum up all the times I got it wrong and that was pretty close to the number of times I got it right.

Benz: In your own portfolio, how do you balance active versus passive?

Rekenthaler: Well, in my own portfolio, I'm mostly the active manager, because I'm picking equities as, I guess, you would say the explorer part of my portfolio, so a minority part of my portfolio, to go along with the professionally managed part. Now, I do have a lot of active managers within my 401(k), but I'm talking outside of the 401(k). My own portfolio is not a--and I've written about this before--it's not exactly a model for anybody else's portfolio.

Benz: You have written about it.

Rekenthaler: I'm about 50%, or even more now because it's gone up in Morningstar stock. And of course, I would tell everybody, don't be half or 60% of your assets in company stock. So, there you go. It's the barber who has a terrible haircut. That's where I'm at.

Benz: When you think about, say, the 401(k) and your holdings within it, the active funds that you have there, are there any funds where you just say, "Now that's an active manager where I have a ton of comfort, where I really like that manager and I believe in what's going on there”?

Rekenthaler: Yes, but I should also confess, I don't actually pick those active managers.

Benz: So, you invest in the managed …

Rekenthaler: I hand it over to Morningstar's managed program, which is Morningstar's advice program that will pick the funds, which I, in good conscience, felt I had to do because I was a part of the group when we launched that. I used to work in that group in that area. So, it would be a bit disloyal of me not to invest in a program that I helped to start.

Benz: Before we leave the user-feedback topic, how about a column that you wrote that was really well received? Can you think of something along those lines? And also, did the positive support for that piece surprise you or did you kind of expect it? Did you think you had written something really good?

Rekenthaler: Well, when I wrote about revenue share--ban all revenue sharing--revenue sharing in mutual funds being when a mutual fund company in one way or another is paying, say, a 401(k) recordkeeper or retail-brokerage firm but the distributor. It's very common, because people tend to notice less when mutual funds collect their money through management fees than when like a broker charges a commission or a recordkeeper charges a fee. So, there's this complicated back-and-forth game, and it's in the disclosure mostly, but who knows and reads those disclosures. So, I came out against that. And that was across the board positive support, even from mutual fund companies. And I was criticizing the practice, but they don't want to be doing it. The advisors don't like it. Investors don't like it. Mutual fund companies don't like it. The only parties that are served well by revenue sharing are the distributors. The distributors aren't reading our material. So, I didn't get that.

I should also point out on your earlier question of controversial columns, and this was back and forth, but the most comments I ever got was when I wrote about high-frequency traders and Michael Lewis' book. And my take was, Michael made a lot out of a little, and high-frequency traders aren't particularly harmful to the marketplace or certainly to retail mutual fund investors. And I'm quite confident that's correct, because I talk to a lot of people. I mean, I talk to people who are expert traders inside the marketplace, institutional traders. I talked to the major mutual fund companies, ask them what they heard. But you know, that book is … it's a great book, but it's a hero and villain book. And the high-frequency traders are in the black hats in that book. So, there were some people that would not be convinced by what I wrote.

Ptak: We’re going to shift gears a bit, and you, I think, are a very avid reader of academic research among other interests. But it often makes appearances in your columns. And so, I'm curious what you think we should be paying attention to right now, academic research that you found especially compelling, perhaps it's something that you've written about, or perhaps it isn't. But is there anything that's caught your eye recently that you think should have our focus?

Rekenthaler: The potentially most compelling academic work I've seen recently, and that I wrote about, was actually an item from many, many years back that has been revisited, about the best way being to evaluate portfolio managers is not what they own, but the company they keep, and that's in the title of the paper. That's a bit convoluted, but the argument is that if you look at a portfolio manager's holdings, and you say, "What other mutual funds, active mutual funds, only securities?" And then, you go look at those funds that own the same securities, and you weight them more heavily by the position, so that a 5% position, it counts for a lot more than just a tiny position. And turns out this manager tends to share a portfolio with a lot of strong managers, and this one with funds that haven't been so successful, that that signal is actually stronger than the portfolio manager's own record.

It does seem complicated and backward way to get the signal. Instead of saying, let's look at the performance record of fund A; instead, it’s let's look at all the performance records of all the funds that have shares of the same stocks and see by that measure, is this manager in good company or bad company? And that signal is more powerful than the fund manager's own record. The argument is the fund manager’s own record just has a lot of noise because the sample size of one. In this way, you're getting a much bigger sample size. But it's a difficult argument conceptually to wrap one's head around and think, "Gee, that signal really is stronger."

But the original academic paper was done many years back and kind of got buried. It showed a strong finding and then Morningstar recently said, "OK, you know, we'll do the same study over a brand-new time period and a larger investment universe, and also found strong results, much stronger results than you normally find in a study that has massive amounts of data points. So, that impresses me. I still don't quite know where to go with it. But I'm impressed by anything that doesn't seem to be a forced finding as opposed to a smaller universe over just one time period, because there's a lot of pressure out there to find something. But this actually seems to be real.

Ptak: Yeah. So, that resonated, but then there's other research that I think you write about that maybe doesn't. Perhaps it's overhyped, or just when you scratch at it a bit, the argument begins to fall apart. And so, I mean, based on your experience, reading many, many papers and pouring through research, is there any advice or lessons you can offer to our listeners about how you separate the wheat from the chaff and really know whether something is substantive versus something that really isn't?

Rekenthaler: Longer time periods are better. More data are better. Seeing something that's been demonstrated over one time period or one investment universe or one marketplace appearing again elsewhere, yes, that can be replicated, duplicated. This is an idea of studies that cannot be replicated are, you know, it's very common across all the sciences, not particularly in the health field where they found so many pharmaceutical and medical studies that when they repeat the study with a different test group, they don't get the same result. They don't find a statistically significant result and have to backtrack and say this--what we thought we found, we didn't find. It's important to remember that the idea of a scientific truth is established by convention in studies of data points. I'm not talking about physics or something like that, or theory. It's entirely arbitrary. You run a statistical test, and if it could have happened less than one time in 20 randomly, you say it's statistically significant at the 5% mark, I found something. If it just crosses over that line, it's statistically insignificant. I didn't find anything. So, this is--it's actually difficult without human intervention. You can't say this really is there, this really isn't. You have to keep redoing it and trying again. Like, for example, with fund expenses, we know, time and time and time again, you look at a study and try to find a correlation between fund expenses and future fund performance. It's there, OK. That's real. There aren't that many other things that are that real, and that consistent.

Benz: Going back to retirement, one question that we've asked several people on the podcast is just the state of retirement readiness in the U.S. And you've stated before that you distrust the term "retirement crisis." So, explain why and talk about what you feel the general state of retirement readiness is in the U.S.

Rekenthaler: Well, I dislike the term "retirement crisis" because the crisis implies to me that this is different than in the past. I don't think when people say retirement crisis, they mean, there's a retirement crisis today, there was one in 2008, there was one in 1998, there was one in 1988, there was one in 1978. But that's what there was, because we're certainly not worse off than we were in the past as a society, and people point to the days of pension funds. And yes, you had a substantial minority--minority--of people who worked in one job at a company that gave to defined-benefit pensions, and they were the classic, worked at the steel company. But there were tens of millions of American jobs that weren't like that itinerant sales jobs and service jobs and all kinds of jobs that weren't just on the factory line. I mean, my parents had two of them. My parents had nothing in retirement. They didn't work in the same company for year after year after year. And those places didn't have defined-benefit plans anyway. So, we're not worse off. Of course, there's great amount of improvement that can be done. So, I object to the term crisis because I think it's a, frankly, it's a sales term. It's a call to action saying: Somehow this time it's different; now we need to act. It's not different now. We need to act, though. But I do object to that.

In terms of retirement readiness, well, younger people starting today, who are in a company that has a 401(k) plan with auto-enrollment programs, I think by and large, will be doing well enough. Their savings rates could be higher, and so forth. But relatively speaking, that won't be a crisis. The problem is, only about half of workers have access to 401(k) or other defined-contribution plans. And those people are probably not saving at all in general on their own, because most of those companies, the ones that are lower-paying jobs, with less-educated workers and less stability in their lives and so forth, and those people are really outside the system. So, yeah, that's a retirement crisis. But again, that was always around.

Benz: How would we help address that do you think?

Rekenthaler: Well, there have been various proposals. I've written about some. I just saw Teresa Ghilarducci. Sorry, Teresa, if I'm pronouncing your name incorrectly. She's an academic who studies 401(k) and retirement issues. And she's got a proposal for a nationwide 401(k) plan out there. There are a number of them out there, but with relatively little government intervention and extra spending, one can extend the 401(k) system to all employers. The problem now is, it's piece by piece. You've got to, as an employer, you have to follow these antiquated rules of setting up your own plan. Why should hundreds of thousands of employers each set up a plan and go through the documentation and the due diligence and all the work? We need a solution that is much more streamlined, and that does involve having some government involvement and new legislation. Make it easy. Make it just--you know, the company doesn't even have to sign up for a plan. The employee can go and just be automatically put into the plan.

Ptak: I think you'd written approvingly of the British retirement system recently, if I'm not mistaken.

Rekenthaler: I would write approvingly of almost anybody else's defined-contribution system of the countries that have them. Because those were designed top down. See, ours is bottom up, right? The 401(k) came out of an obscure section of the IRS code that was written in the 1970s without the intention of being America's mass retirement plan. And credit good old-fashioned American ingenuity--finding me something in the tax code and creating something that was tax sheltered out of it. But it wasn't built for this use. And in Australia, and in New Zealand, and in England, the United Kingdom, some of these other countries, these are more recent developments. They've looked at what we did, and they said, how can we improve upon this and they have. So, why aren't we looking elsewhere and saying, how can we improve upon what we're doing? We don't always have the perfect answer every time. Give us credit for having an early answer. That doesn't make it perfect.

Ptak: Yeah. Maybe shifting gears a bit to talk about innovation. And certainly, you've also had an opportunity to see many ideas come and go in the industry. I think you referred earlier in the conversation to government-plus funds, which probably in their day were built as an innovation.

Rekenthaler: Oh, they were.

Ptak: And so, reflecting on that. What do you think has been the best fund innovation and what was the worst that you've seen in all your years covering the industry?

Rekenthaler: I'm going to put index funds outside of that since the first index fund was from 1975. And I was in junior high school. So, I wasn't at Morningstar. So, I'd have to say ETFs, exchange-traded funds, were the best innovation. Jack Bogle famously was against them thinking they would encourage people to trade long-term portfolios. In practice, it doesn't seem to have worked that way. Individual investors don't use ETFs differently than they use mutual funds. And if they over-trade ETFs, they also over-trade mutual funds, but it's not that the ETFs have made it worse. And it's a, the fact that its structure is a little different than a mutual fund; it's a popular and attractive investment, but I think it's $6 trillion now, globally, I believe that number is--at any rate, I think you'd have to say, and they tend to be low cost as well.

In terms of worse …

Ptak: It's hard to choose.

Rekenthaler: Well, yeah. Luckily, the good thing is, the best change has trillions of dollars in it. Anything that would make my worst list is pretty much gone and never was that popular--whether you're talking about the government-bond funds that turned out the government was Argentina. Argentina and Mexican peso bonds, or dollar-denominated bonds, but they were from Argentina and Mexico and not the United States, or the Internet funds in the late 90s that came about, or the tactical-allocation funds that were the rage after 2008. After the market crashes, the time is not to try to defend against the next crash but get in there. I could go down the list, but they're relatively small fry. That's why I think, you know, the industry has clearly improved, because the mistakes aren't right in front of us. They never got that big. And they've pretty much been buried, too.

Ptak: Since you mentioned Jack Bogle, he's someone you knew, and I think you'd consider a friend. I'm curious, what as you reflect on the time that you spent with him, what did you learn the most from him?

Rekenthaler: Well, certainly, what impressed me most about Jack was candor. You know, I give him credit because he was somebody who genuinely liked reporters, and I view myself in this case as a reporter, although it's a little different than the standard reporter's job. In fact, I get interviewed by reporters, but we're still commenting on the fund industry. Meaning when he was interested in what we were doing, he was actually interested. And unlike a lot of people who are constantly being appealed to by people who hope they can use us, right? So, we know that's part of the job. Not all of our friends are friends. Where you can tell the differences, that people who aren't your friends are never going to say something unkind. Whereas when I wrote an article, that was not actually critical of Vanguard, but he thought it was. It was way back in the day; it was a bad article, by the way. It was critical of some of the academic research and Jack took that as being critical of index funds and some of the things that Vanguard did. I got a three-page scathing letter about what a terrible job I had done. Now, that's impressive, because he's trying to cultivate me, but he's telling me how terrible a job I did, and that was dictated from his hospital bed, three or four days after he had his heart surgery. He was, from his hospital bed, he got himself so worked up reading my commentary that he dictated it to his assistant, and I got, you know, old-fashioned snail mail and it was quite a corker. It clearly had been unedited, like he said it to her almost like somebody at a bar. Probably he was doubly cranky because he just had heart surgery and wasn't feeling so great.

The other thing from Jack, he really did care about investor returns. He really did want people to get better results in their funds, and genuinely had mixed views on Vanguard becoming too large or having too many assets. I'm not saying he was St. Jack, and that he didn't enjoy the business success. But he was focused and that came through too; he was focused on shareholder results.

And, finally--I keep thinking of things as we talk--he was willing to admit mistakes, maybe not always publicly, but certainly in private. For example, he regretted--he was quite delighted when he launched the Vanguard Growth and Vanguard Value Indexes in the late 1990s. He had seen the research, how growth stocks and value stocks would differ. And he thought it was pretty cool. They could split this the index into the growth piece and the value piece, and they could behave differently. And Vanguard, to my knowledge, was the first firm to have growth and value index funds being offered. But he later regretted it and thought that was--in a way he'd started what he viewed as a very bad trend, more and more complicated versions of not buying the entire market index and becoming effectively active index managers by indexing only a portion of the market or re-creating indexes. He admitted to that.

Benz: People glommed on to the growth piece at the wrong time, right?

Rekenthaler: He never did admit to being in the wrong view on the ETFs. So, if he were here now, he would tell me off with that comment. But …

Benz: Who do you see stepping into Jack Bogle's leadership shoes in the industry? Anyone?

Rekenthaler: No.

Benz: Do we need that?

Rekenthaler: It would be good. Yes. I think we will survive without it. But it would be beneficial to all parties to have a strong voice for investors and for doing what's right for the investors at a major firm within the industry, yes.

Ptak: And if that person stepped up, what do you think that they should be agitating for? What's sort of the key advocacy area for fund investors right now?

Rekenthaler: Well, I think revenue share would certainly be one of the issues. You asked me a question that I could answer better a week from now or in a future column, which won't help the people in the podcast. But I do think the fact that revenue sharing is still in existence, and we've got all these transfer payments, which Vanguard and Bogle haven't done, that needs to end. I mean, that just feels so antiquated and unfriendly, consumer unfriendly. Now, Vanguard doesn't engage in that practice to my knowledge, and maybe a couple of other companies, but there's nobody out there actively leading the charge and saying, "As an industry, this is where we're going as a firm, follow us; let's not do this anymore." If you're buying a fund, you're paying exactly what the fund charges, no more, no less. If you've got recordkeeping services, you're paying the recordkeeper what it's getting and there aren't any under-the-table payments, backdoor deals, whatever. Kickbacks would be the strongest language--whatever you want--that help determine what partners or what other companies they're working with, because there's cash involved.

Ptak: One of the other hot topics in the industry right now is governance, and maybe shifting back to indexing, and I know that you're familiar with this topic, though perhaps our listeners less so. One of the more controversial attacks that's been waged against indexing is this common ownership argument. And the notion is that indexing is anticompetitive by its nature, I think, some proponents of that argument would say. And so, my question for you is, do you buy that and more generally, do you think a world increasingly dominated by indexing is that compatible with good governance?

Rekenthaler: To address your first question, the argument that index funds create a less than competitive situation, it's a difficult one because I don't see active managers. Let me take a step back for a second. Let's say I'm an active manager, and I own Coca-Cola stock. I don't own Pepsi. Do I want Coca-Cola to perform well? Yes. Will that likely? Well, I don't really care if it performs well at the expense of Pepsi or not. I just want Coca-Cola to perform well. I want Coca-Cola to grow its earnings. Whether Coca-Cola grows its earnings by colluding with Pepsi and having price umbrella. That works for me, right? Just speaking as somebody who owns Coca-Cola stock wants that price to rise. The price is going to rise if their earnings grow. They could grow their market share. They could grow the earnings by raising prices and Pepsi raises its prices. It doesn't matter to me.

The underlying logic of the argument that index funds are anticompetitive is that active managers are out there telling their companies to increase market share and bash in the heads of the competitors. I don't think that's true at all. They're just telling them figure out how to grow your earnings. And that's what index funds want too. So, I think in practice, the behavior is not as one would suggest. And we know index funds--we know that explicitly index funds are not, they're not giving different advice to corporate managers than the typical active manager is doing. I'm setting aside the activist investor, which is just a handful of hedge funds or something. So, we can talk about this topic a lot longer. But no, I am not convinced by that argument.

Ptak: What about shifts in the way some have come to think about what has been called the doctrine of shareholder value? And I think this is a topic that you've have rift on from time to time. Do you think it's folly for firms to care about other stakeholder groups besides their firm's shareholders? And to the extent that they do consider other stakeholder groups, what do you think the implications are for investors, for instance, their stock shareholders?

Rekenthaler: Before I answer that I do want to follow up with … because I had an additional thought on that final question.

I did talk with Jack Bogle very late in his life about … he was interested in this subject of are indexes anticompetitive. And as you might suspect, from the founder of index funds, he didn't think index funds had a harmful effect upon competitiveness. But he did think that the index funds were becoming too large; that the major investment managers in index funds are becoming too large, perhaps not from actual effect on the market, but from a perception, view perception. He said, "You can't have two or three companies owning half the U.S. stock market. That just doesn't feel right." And the government's going to get involved at some point and to change that.

Now, to return to your question: Oh, shareholder value, there we go. When I was in business school, which was in the 90s, shareholder value was all the rage. In fact, I won't quite say that Chainsaw Al was presented to us as a hero, but pretty close. The corporate heroes were the turnaround CEOs who came in and fired people, because they made businesses more efficient and American businesses in the 70s and 80s had become fat from empire-building CEOs. And that's at least at University of Chicago, that's what they taught us in business school. It was kind of cutthroat. And the idea that raising shareholder value by increasing the price of the stock was basically the only primary--not just the primary task of the CEO--the only task. That idea slowly is changing. And you see increasingly respectable, prominent people whose capitalist credentials are unquestioned; not just right, socialist politicians or something saying we need to include more people. And there's plenty of global precedents for this--many countries outside sort of Anglo background, like in the European countries, there's a tradition of considering labor unions and employees and stakeholders and communities of stakeholders.

Yeah, I mean, now we're varying--I don't think they are a major investment. We can talk politically, whether we agree with that or not, and the implications of that, which is for a different discussion. But in terms of the investment results, I doubt that will very much affect investment results. It's possible it'd quite profitable while considering other aspects. And I also think that raising shareholder value is and will be by far the largest and most important metric by which CEOs will continue to be measured. Let's face it. The CEOs of companies that are growing their stock prices are going to keep their jobs and are going to be rewarded very handsomely. And those that might hold up a resume filled with community achievements when their companies are struggling are still going to be criticized and probably lose their jobs.

Ptak: Maybe we will widen out in our closing questions and something that I've always been curious about is, who you read religiously that you'd recommend to others who are interested in investing in finance? Who can they not afford to miss in your opinion?

Rekenthaler: Well, when I arrived at Morningstar, in February 1988, at that time, Joe Mansueto, our CEO, gave everybody a copy of Berkshire Hathaway's report and said you need to start by reading Warren Buffett, which I did. And you know, I think most people here have read Buffett, but his ability to convey complicated issues in simple ways and to cut through a lot of pretense is admirable. What disappoints me was in 1988 I didn't buy any Berkshire Hathaway stock; well, maybe I didn't quite have the money for it because those shares are expensive. But it took me many, many years, took me another 20 years to buy the stock. And I saw Joe later. And I mentioned that to him and turned out he hadn't bought the stock either. He had the money. He was giving out Berkshire Hathaway reports saying this is the greatest investor in America in 1988 and he didn't buy the stock. So, there you go. I have made the same mistake as a multibillionaire. It's not so much that I read this brighter or that portfolio manager as, you know--I try to stay on top of the leading periodicals: The Wall Street Journal, The Economist, Barron's, back when Bogle was publishing speeches and writing speeches, I'd read all of his materials as well.

So, I would have given you a different answer 20 years ago when I was a fund manager, and I was covering a lot of active funds and there were certain, like James Gibson at the Clipper Fund and there were various--you know, GMO has good reports as well. So, that would be one example of active manager. But I'm doing less of that these days.

Ptak: Maybe we'll close with this question. I think you've said in the past you've learned to ask yourself how could I be wrong? And so, I'm curious in what realms do you find yourself asking that question most often and how do you obtain the knowledge or the expertise you need to answer it?

Rekenthaler: Mostly, how could I be wrong is when I'm evaluating academic papers, because they're complicated, and they've got a lot of math in them and I can handle some of the basic statistical tables and so forth. But when it gets into the--some of them have a higher-level math, then I call in help. I know people who know things, and they're generous, kind enough to share their views with me. So, I'll send this off to them and say, "What do you think about this? Am I right? Where could I be wrong?" So, it's a know when to ask for help. We all … we don't know it all.

Ptak: Well, John, you've been generous and kind in sharing your views with us and our listeners. Thanks so much for joining The Long View. It's been great.

Benz: Thank you, John.

Rekenthaler: Thanks, as always, Jeff and Christine.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

Benz: You can follow us on Twitter @Christine_Benz.

Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)