How Today’s ETF Market Compares to Gimmicky Funds of the Past

On this episode of The Long View, John Rekenthaler, best known as the author of “The Rekenthaler Report” on Morningstar.com and who is retiring from Morningstar after 36 years, is discussing his work on Morningstar’s foundational methodologies, including the Morningstar Rating and Morningstar Style Box, what he has seen change in the fund industry, and how the retirement business has grown since he helped launch Morningstar’s.

Here are a few highlights from Rekenthaler’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz.

How the Fund Industry Has Changed Since John Rekethaler Started

Christine Benz: Maybe you can talk about how the fund industry was situated when you started. There were a lot of funds cropping up and being introduced. Active management was kind of the standard.

John Rekenthaler: That’s right.

Benz: And fees were much higher than they are today, but maybe you can set the stage for what the fund industry looked like when you started.

Rekenthaler: The industry was quite different. Now, it’s a fully mature industry, with giant Vanguard, BlackRock, State Street, Fidelity, a few giant names with a lot of index funds, and all the funds that sell these days are low-cost. Back in the day was a lot more Wild West. I started in 1988, really the modern fund industry started in 1984, say. The industry had almost died during the 1970s because stock and bond returns were so bad. It was just the invention of the money market fund—there was more money in money market funds than in the stock and bond funds for a while. But the stock and bond markets in 1982 started their 1980’s rally, and money started to come into the industry in the mid-80s. And it was booming.

Our timing was very good in terms of getting in there when the fund industry kicked off. But it was a lot of companies throwing stuff against the wall trying to figure out what stuck. So, a lot of gimmicky funds. We see that somewhat in the ETF marketplace today. But a big difference was that the brokerage firms thought that having the distribution, having the brokers, that was the key to success was having a closed system. You had Prudential beige funds, you had Payne Webber funds, you had Dean Witter funds, you had Merrill Lynch funds, and you had shares of the Lehman funds. Vanguard wasn’t a top-10 fund company at the time. So these load funds, that was the terminology back in the day, brokerage-sold so you could never buy a Dean Witter fund unless it was through a Dean Witter advisor. But then on the flip side of that was a Dean Witter advisor was supposed to only sell Dean Witter funds.

Now that model didn’t turn out well in the end because a lot of those funds weren’t very good—customers felt they were being fed something rather than the best of the industry. It wasn’t a customer-friendly model. And then you had a lot of small boutique firms without that distribution, just hoping. They were like lottery tickets. I mean, $5 million funds run by somebody out of their garage. And if they get three years of really good returns in a row, maybe they’ll get noticed. Those people will talk to you. I guarantee you that. So, one of the stories I tell is about calling a guy, and his wife picked up the phone, and she said, “Bernie’s mowing the lawn right now.” And then you hear, “Bernie, it’s Morningstar!”

Benz: Did Bernie come in?

Rekenthaler: Bernie came in. Bernie came in. You don’t get too much of that these days.

Gimmicky Funds That Came Out During the Rise of the Fund Industry

Lefkovitz: I’m curious, what were some of the gimmicks that you saw early in your career?

Rekenthaler: Well, some of them are eternal. Like when I started at Morningstar, the biggest mutual funds in the US then, probably the world, were government-bond funds that wrote options against the government. They would sell options, call options on the bonds, and distribute the proceeds in those options as yield. Technically it was not income; that’s short-term capital gains. But it was like you were getting a government-guaranteed security. You used to be able to say government guarantee, but you can’t say that anymore because, as we know—we learned a lot in 2022—bonds can go down and lose price. People were shocked when they did. So, there were a lot of option-writing government bonds. And now that’s back in.

You’ve got all kinds of funds citing their income these days, writing options. Again, they’re in ETFs now rather than mutual funds. And they’re equally misunderstood, at least at a lower cost today. Those funds tended to have 1.5% expense ratios on the government bond fund.

There were a lot of market-timing funds, especially after 1987, because after the crash, everybody wanted to dodge the next crash, but you’re not going to have the next crash probably. And by the time the next crash happens, all those crash-dodging funds have disappeared because they did poorly. So, that’s another ironic thing.

Why Market-Timing and Tactical-Allocation Funds May Not Be a Good Bet

Lefkovitz: Market-timing meaning tactical allocation?

Rekenthaler: Market-timing. Not tactical allocation in the sense of, “I’m 60% stocks, maybe I’ll change to 50%.” Like, “I’m 0% stocks, I’m going to go to 100%, or I’m 100%, I’m going to go to 0%.” So, funds that can dodge the crash. And then people publishing studies—these five or seven funds managed to get out in October 1987 and dodge the crash. They dodged like the next 11 crashes that didn’t exist.

So, they all trailed the market. It was a long time until there was a real crash. It wasn’t really until the 2000-02 technology crash. It wasn’t until 13 years later that there was something to dodge. By then, none of them existed.

So, I developed a distaste for market-timing and tactical-allocation funds that has really not changed to this day. I will change my opinion if the facts convince me, but they have not.

There were others. There was something called a short-term multimarket income fund. How’s that for a name? And they would buy high-yielding European currencies—this is before the euro. So, they would buy like the Italian lira or the Greek drachma. And they would sell the deutsche mark, sell the low-yielding, and see that would give you a spread. And the currencies were supposed to converge because there was an exchange-rate mechanism that was going to create the euro, and they didn’t tell you why it was the perfect safe trade. And then it fell apart. The exchange-rate mechanism didn’t work, and actually, the lower-yielding currencies went in the opposite direction and lost relative to the high yield. So, the stuff that you were long on outperformed the stuff you were shorting, and then all of a sudden, these things that were sold as cash alternatives lost like 8% or 10% in about six weeks, and everybody redeemed them and blah, blah, blah.

So, this is the history of complex funds that aren’t well explained. And I knew that. This was early in my career. This could be pretty complicated stuff, these short-term, multimarket income funds—long these currencies, short these currencies, exchange-rate mechanism.

And I knew that there was more possibility of danger than any of the portfolio managers would let on, but nobody really told me when I would interview the portfolio managers. And that was another lesson for me, too.

And I think it wasn’t always just trying to deceive me, it’s because they didn’t see the possibilities, either. They were believers. And it was hard for them to confront the possibility that their beliefs might work in a different direction. That also was a lot of early lessons about understanding psychology and understanding most of the time when people are deceiving you, they’re deceiving themselves as well. I mean, sometimes. There are definitely people out there who are just out there to sell something, but not always. If you want to be a good investment analyst or just an analyst in general, you need to understand how psychology plays into how people think about risks. And I always thought that the most valuable service that we do for people is to explain the risks in funds because we can’t predict the future. But we can show them the possibilities, what kinds of factors these funds might be susceptible to, what are the dangers.

In some cases, this fund doesn’t face these particular dangers. If people understand the possibilities and feel well-informed, they’re much less likely to make an emotional decision and will make a more rational decision. I think that’s our role. Maybe there’s someone here who can predict where the markets are going, but I haven’t been so good at that. I’ve got a 50% track record.