Why We're Moving DoubleLine Total Return Bond Fund's Rating to Neutral
A talented manager, but we still have questions about the fund’s process and firm stewardship.
In our analysis published today, we assigned DoubleLine Total Return Bond (DBLTX) a Morningstar Analyst Rating of Neutral. The following Q&A explains the rationale supporting the Neutral rating and key questions we would seek to satisfactorily answer in order to recommend the strategy.
Q: Why is DoubleLine Total Return Bond rated Neutral, and what does that mean?
A: We assigned a Neutral rating because we have a mixed view of the fund. We respect the skill and experience of its manager, Jeffrey Gundlach, who has amassed an impressive record here and at previous charge TCW Total Return Bond (TGLMX). We also think the fund is priced competitively--fees on its institutional share class are below the category norm. This explains the Positive ratings we have assigned to the People, Performance, and Price pillars. However, we still have questions about the prudence and repeatability of the fund’s process and the extent to which its advisor, DoubleLine Capital Management, is demonstrating its commitment to shareholder interests. This explains the Neutral ratings we have assigned to the Process and Parent pillars. Taken together, the fund’s Neutral rating means we do not have enough conviction to recommend it.
Q: What are key questions you have about the fund’s process and the firm’s advisor?
A: This is a fairly sophisticated mortgage strategy. Therefore, it is important to assess how management is assembling the portfolio and balancing the risks therein. For instance, Gundlach has historically talked about offsetting the risk in the fund’s high-quality and rate-sensitive agency mortgage portfolio with its more credit-sensitive nonagency residential mortgage-backed securities portfolio. As the nonagency RMBS market has shrunk and prices have recovered, how has portfolio construction evolved? In addition, given Gundlach’s centrality to the fund’s success and considering the firm’s asset growth, it is essential to evaluate stewardship issues such as succession planning and the advisor’s approach to managing capacity. We have not been able to satisfactorily answer these questions using publicly available sources of information. DoubleLine has repeatedly declined our requests for information.
Q: Do you always need access to a firm in order to conduct your research and assign a rating?
A: No. Access to a firm is not a compulsory part of our research process. However, when we are evaluating sophisticated bond strategies like DoubleLine Total Return Bond, publicly available information often does not suffice. This is not a failing of DoubleLine’s, per se, but rather reflects the fact that disclosure and reporting practices have not kept pace with financial innovation. In addition, firms do not ordinarily publicly disclose information on a range of topics including the details of succession planning or capacity management. Given this, we routinely conduct interviews with fund managers to better assess portfolio construction, risk management, key performance drivers, and firm stewardship, among other issues. What we ask are the kinds of basic due diligence questions that all other managers answer and that any fiduciary, whose interests we're trying to represent, has a responsibility to ascertain.
Q: You’d previously said the fund was Not Ratable. What changed?
A: We revisited our decision to assign a Not Ratable designation to the fund. We originally assigned Not Ratable to the fund in July 2014 and reaffirmed it in July 2015. However, upon further review, we think it makes more sense to assign a rating to the fund that reflects what we know rather than, in effect, withhold a rating absent complete information. Leveraging the analysis we have conducted and considering the unanswered questions that remain about the fund’s process and DoubleLine’s stewardship, we do not have enough conviction in the fund to recommend it. We feel that the Neutral rating we have assigned better conveys that view than Not Ratable, hence the change.
Q: How did you arrive at the Not Ratable designation in the first place?
A: We initiated the fund's rating at Neutral in 2011 and conducted a due diligence visit in April 2012. Shortly thereafter, DoubleLine denied us further access to the firm’s personnel and subsequently declined repeated requests for information. For a period of time, we left the fund’s Neutral rating in place, leveraging extensive research we had conducted up to that point. However, after several years had gone by without additional information from, or substantive contact with, DoubleLine, we determined that we lacked sufficient information to fully and fairly assess the fund’s process or stewardship practices. That prompted the change to Not Ratable in July 2014, a rating we reaffirmed in July 2015.
Q: Why doesn’t Not Ratable fit anymore?
A: As mentioned, in general we believe we can better serve investors by assigning a rating that reflects what we know than withholding a rating absent complete information. For a time, we felt that Not Ratable usefully fit the circumstances--namely, a temporary lack of information prevented us from fully and fairly assessing the DoubleLine fund’s investment merits. As time passed and DoubleLine’s stance became clearer, we questioned whether Not Ratable was the best fit. Absent additional information, we concluded that we do not know enough about the strategy or the firm’s stewardship plans and practices to recommend the fund, explaining the Neutral rating we assigned.
Q: Do you rate other strategies like this one? If so, can’t you leverage that knowledge to rate this fund?
A: We research and rate a variety of mortgage-focused funds. These include funds that follow a relatively plain-vanilla approach that emphasizes agency-backed mortgage pass-throughs as well as those that invest heavily in credit-sensitive nonagency mortgage bonds backed by residential or commercial mortgage loans. Meanwhile, some invest in more-complex securitized structures that carve up the cash flows of the underlying pool of loans, while other absolute-return-oriented mortgage funds have the ability to go long and short. While mortgage funds share certain traits in common, even seemingly similar strategies can exhibit strikingly different risk and reward profiles. This can reflect variations in the way managers select mortgage securities, which depends on the inputs being used to evaluate a given mortgage pool or tranche, as well as differences in particular mortgage sectors being emphasized. For these reasons, while some analysis can be leveraged, we still believe it is important to evaluate each strategy on its own, so as to incorporate its unique attributes into the assessment we are making.
Q: How long have you been covering the DoubleLine fund or other funds that its manager ran in the past?
A: We have been covering the DoubleLine fund since 2010 and covered Gundlach’s previous charge, TCW Total Return Bond, since 2002. In the 1990s, we also covered the closed-end TCW Dean Witter Term Trusts that Gundlach comanaged with his current DoubleLine colleague, Phil Barach.
Q: How have your views evolved over that time?
A: We have consistently praised Gundlach’s skill and experience over time, extending to our most recent analysis of the DoubleLine fund. In fact, we nominated him several times for some of the highest honors we bestow, including Morningstar Fund Manager of the Year and Morningstar Fund Manager of the Decade. We also highly recommended his previous charge, TCW Total Return Bond, which was a longtime Analyst Pick (the precursor to our current Gold rating). When Gundlach left TCW and formed DoubleLine, we were enthused about his and his firm’s prospects. However, at the time we initiated the fund’s rating at Neutral in 2011, we had become concerned about the risks presented by a sizable stake in esoteric mortgage-backed securities that the fund had taken. While those risks did not materialize and the fund’s performance has since been excellent, it was shortly after that initial rating that DoubleLine denied us further access to the firm’s personnel and declined subsequent requests for additional information.
Q: The fund’s performance has been excellent. Isn’t that enough to earn your recommendation?
A: No, it is not. While past performance can yield insights into a strategy’s risk and return profile and help to corroborate or dispel conclusions drawn about the process and how it is implemented, it is not a divining rod. That is why we evaluate other factors that we believe are more-predictive of future returns--the People, Process, Parent, and Price Pillar ratings mentioned above. We do not feel we can really evaluate a fund’s merits--that is, understand it--if we are not looking beyond past performance, something we have consistently sought to do in covering the DoubleLine fund.
Q: What additional information are you seeking? What would you ask if DoubleLine granted you access to firm personnel again?
A: Portfolio Construction:
o What fundamental traits are the team emphasizing in its nonagency RMBS stake, such as collateral profile, geography, servicer behavior, potential to benefit from legal settlements, seniority in the capital structure?
o Why has the composition of the fund’s nonagency RMBS stake shifted more toward subprime in the past 18 months, and what parts of the subprime market offer the best opportunities, in the team’s view?
o When nonagency RMBS were priced at sizable discounts to par value in the aftermath of the financial crisis, the team stress-tested individual holdings using Draconian assumptions regarding borrower delinquency and home price values. How have the team’s stress-testing assumptions changed following a period of recovery? What are the greatest risks to these positions in the current environment?
o How important is continued home price appreciation for the performance of the fund’s nonagency RMBS positions?
o What are the characteristics of the fund’s stake in agency collateralized mortgage obligations, and how have these changed?
o What factors drive security selection in these sectors?
o Under what circumstances would the team consider investing further down in the capital structure in any of these areas?
o What factors does the team consider in conducting loan-level analysis of the underlying commercial real estate portfolios?
o Regarding CLOs:
§ How does the team balance its analysis of the underlying corporate debt with structural protections of the security? In other words, does the team need to have a positive view of each of the underlying credits in order to invest or will it rely on the structural seniority of the tranche to protect its investment?
§ Does it avoid CLOs with heavy exposure to less desirable industries?
§ What criteria does the team consider when evaluating the competency of a CLO manager? Are there certain managers the team will avoid?
§ How does the team assess the liquidity of individual CLO positions?
§ Why would the team choose to invest in CLOs managed by one firm versus another?
o How does valuation factor into bottom-up security selection in these areas?
o Why was Sherman chosen for the role? What unique or complementary skills does he bring to it?
o What new responsibilities will he assume in the short, medium, and long term?
o Is DoubleLine’s investment staff full, or does the firm have research holes to fill?
o How does DoubleLine recruit new analysts? What are the tenures of the analysts at the firm?
o What has turnover been like among the investment staff?
o What does career pathing look like at DoubleLine?
o It has proved difficult for other boutique firms to move past the founder. Has the firm’s leadership thought about what it might do to make that eventual transition successful?
o Who challenges Gundlach the most? How can the firm ensure that the next generation of senior leadership is not just deferring to Gundlach?
o Who has equity ownership in the firm, and how is it determined?
o Do only active employees (other than Oaktree) have equity in the firm? What happens when they retire or leave the firm?
o Is there a long-term plan to transfer ownership from Gundlach to others?
o What is Oaktree Capital’s exit strategy?
o Why is it important for DoubleLine to offer equity strategies? Whose decision was it to offer equity funds?
o How did the firm go about building out its equity lineup and the infrastructure to support it? What has happened since? What did the firm learn, and would it have done anything differently?
o What is the process for launching new funds? What factors are taken into account in deciding whether or not to add product offerings?
o Is there an effort to actively diversify the firm’s business mix (both by asset class and distribution channel), and how does it intend to go about that?
o DoubleLine’s chief compliance officer and general counsel are one and the same. Is there a plan to separate the roles?
o What does the compliance function look like at DoubleLine? Have resources dedicated to compliance grown with assets?
o Has there been any recent contact with the SEC? What, if any, deficiencies did it find, and how did the firm address them?
o What is DoubleLine’s approach to fee-setting?
o Why are there no management-fee breakpoints on Total Return, in particular?
o Why has the firm recouped past waived fees?
Miriam Sjoblom, Director, Fixed Income Ratings, contributed to this column.
Jeffrey Ptak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.